Smart Savings: How to Invest for College
Saving for a child or grandchild’s college education is one of the top financial goals for many investors, and the expense of attending a private or public university continues to rise even higher year after year.
According to the latest data from U.S. News, the average annual cost of tuition and fees at a private college or university for undergraduates was $36,801 for the 2019-2020 school year, followed by $22,577 for an out-of-state public university and $10,116 for a public in-state school. Those costs quickly multiply when adding living expenses, the 4-6 years it takes to acquire the desired degree – and multiple children. These days, many families also bear the added cost of sending children to private K-12 schools.
529 Savings Plans
One of the common tools for saving for education expenses, including both college and K-12 tuition, is a 529 plan. These savings plans function much like a Roth IRA. Individuals can contribute after-tax investment into a designated 529 plan. Earnings accumulate on a tax-deferred basis and distributions are not taxed federally when used for qualifying education expenses. Some states also offer state income tax deductions. Those savings can be used at more than 6,000 U.S. colleges and universities and more than 400 foreign colleges and universities.
The 529 plans are relatively easy to set up, and the tax-deferred aspect is an attractive incentive. However, there also are some downsides that should be considered. A 529 has to be designated for one specific child. So, if you have multiple children it would require setting up separate accounts for each child. Additionally, if the child doesn’t go to college, or does not use all of the money in the account, then the remaining funds that are withdrawn for non-educational use are subject to taxes and also may be subject to an additional penalty. Fees are waived in certain circumstances, such as if a child receives a scholarship or decides to enter the military.
Custodial and UGMA/UTMA Accounts
Another college savings option is to open a traditional custodial account for a child. The adult, such as a parent or grandparent, maintains control over investment decisions in the account. The child can access that account once they become an adult, which depending on the state, is usually between 18 and 21. UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) are custodial accounts that are commonly used to hold and protect assets for minors until they reach the age of majority in their state. These accounts typically allow stock, bond, and mutual fund investments, but not higher-risk investments like stock options or buying on margin.
One of the main differences with custodial accounts is that the money saved does not have to be spent specifically for education. Although there are some potential tax advantages of custodial accounts, they are not as great as a 529 plan. Because the assets are considered the property of the minor, there is some shelter from the parents’ tax bracket. A certain amount of the investment income will go untaxed while an equal amount is taxed at the child’s tax rate. However, the balance is taxed at the parents’ marginal tax rate, which could be a negative for families in a high tax bracket.
How to find the right fit?
Many investors do want to plan ahead and start investing for college, but don’t want to be tied down with rigid structures. In that regard, investing for college can be one of the financial goals an individual or family sets as part of their broader financial planning strategy. Keeping college savings in mind as part of a bigger investment portfolio also allows an individual to plan for the financial needs of multiple children from the same “bucket” so to speak, without having to create separate designated accounts.
This method also gives the parent or grandparent more control over how money is invested. For example, instead of being limited to vehicles that only allow for investing in mutual funds, stocks, bonds, and CDs, portfolio investing allows investors to also allocate money to alternative investments, such as private equity real estate. Investors also have more control on how and when that money is spent. For example, an investor may decide to give each child an equal lump sum to pay for college, or simply use those funds to pay college tuition bills when – or if – they arise. Money also can be gifted to a child to help pay for a trade school or provide a gift or low-cost loan to help a child set up a new business in lieu of enrolling at university.
Giving the rising cost environment, the best advice is to start saving early and talk with a financial advisor about the different options to find a plan that fits into your overall financial planning goals.