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Education Savings Tools – how to choose a savings option

February 24, 2020 by The Trust Company of Tennessee

College is quickly becoming more and more expensive.  As we plan for education costs, we’ve started to grow college expenses at a higher inflation rate than healthcare.  Long gone are the days where you could work through school, avoid loans, and come out debt free.  As a result, we’re kicking off an education planning series so you can learn more about the best ways to save for college.  

First, saving to the bank is not enough.  While starting to save a little extra each month is a great habit (and it really does add it up!) cash alone does not provide enough growth.   

Fortunately, there are multiple ways to save for college and even K-12 expenses.  Before choosing an investment, make sure to consider the following items.   

  • Taxes now and taxes at withdrawal – always check to see if there are any tax consequences now or at the time of a distribution.  
  • Contribution Limits – there may be contribution limits associated with what you can save each year to some investments.  
  • Financial Aid Eligibility –understanding the EFC (expected family contribution) formula is key.  Assets or income owned by your child are considered at a much higher rate, than parent-owned assets and income.   
  • Income Phaseouts – some attractive savings vehicles are only available within certain income limits.  
  1. 529 Plans – probably by far the most popular tool for education planning.  Provides tax-free growth if used for qualified education expenses.  With no contribution limits and no income phaseouts, saving to a 529 account is available to everyone.  Further, 529’s are usually owned by a parent, which means they have a low impact on the EFC formula.  Did I mention you can now use 529’s for K-12 tuition?   
  2. Coverdell ESA – 529’s less popular cousin, but still beneficial.  Coverdell accounts also provide tax-free growth for qualified expenses and have a more liberal definition for qualified education expenses. However, they come with a few more restrictions than 529 plans. Subject to a contribution limit of $2,000 per year that must be made before your child turns 18, and income phaseouts for contributors.   
  3. UTMA/UGMA – while an UTMA or UGMA is not generally thought of as an education savings tool, they can still be used for college or private school tuition.  Key things to remember: this is an investment account for your child, they gain full control at age of majority (generally 21 or 24 in Tennessee).  Depending on the size of the account, this could have a significant impact on your child’s EFC as it is considered an asset of your child’s and income received is income to your child.  That also means there could be tax implications now for this investment, as this type of investment is subject to kiddie tax.  
  4. Roth IRA – at this point, you may be double checking the title of this article and asking, “Why is this included?”.  Roth IRA’s are becoming more and more popular as a way to save for college because they provide parents with flexibility; generally attractive to parents that don’t want to invest in a traditional education vehicle for fear their child may take a less traditional path.  Typically, distributions taken before age 59½ would be subject to tax penalties, but there is an exception for qualified education expenses.  Since this is also a retirement asset and generally owned by a parent, Roth IRA savings have a very low impact on your child’s EFC.  

The next few posts in our education series will take a deeper dive into each of the mentioned savings vehicles.

To ask questions or talk with one of our financial advisors, click here.

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