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Saving for College: What Are Your Options?

Key Points
  • Getting a head start on college saving is smart but how you save is also important because of taxes and financial aid eligibility.

  • 529 plans and custodial accounts are two common college savings vehicles but they have some significant differences.

  • Whichever you choose, don't sacrifice your own retirement for a child's education!

Dear Carrie,

As a relatively new parent, I’m confused about the best way to save for my son’s college. He’s only 3 years old, but I want to get started now. What would you suggest? 

—A Reader

Dear Reader,

You are smart to start thinking about saving while your son is still so young. As parents, we have a lot of financial obligations, and paying for college is one of the toughest of all. That’s especially true now with college costs rising at a rate much higher than inflation. In fact, according to the College Board's College Cost Calculator, a child born this year may need more than $150,000 in today’s dollars to attend a four-year, in-state public university, assuming annual cost increases of 3 percent; private schools may cost almost twice that much (see “Up, up and away,” below). There’s just no getting around the fact that college is expensive.

Up, up and away

A child born today could to pay nearly twice as much for a four-year college education, be it public or private.

Cost of four-year, in state public college will increase from $85,788 to $152,753 in 18 years. Cost of four-year private college will increase from $168,896 to $300,734 in 18 years.

Source: The College Board. Estimates assume annual tuition increases of 3%.

So, clearly, starting early and contributing as much as possible are both important. But how you save is also important, for a number of reasons, including the impact on taxes and financial aid eligibility. Let’s take a look at the two most common college savings vehicles.

529 plans

I’m a big fan of these state-sponsored education savings accounts, which have four main benefits:

  1. Tax advantages: Although you contribute to the account with after-tax money, your investment grows income tax-free and you don’t pay federal taxes (or penalties) on withdrawals so long as they’re used for qualified expenses such as books, room and board, and tuition. Many states offer residents a full or partial tax credit or deduction for contributions to their state’s plan—and some states allow you to deduct contributions to any plan.
  2. Improved financial-aid eligibility: A 529 is generally considered a parental asset. That’s important because up to 5.64 percent of parental assets are factored in when calculating your Expected Family Contribution (EFC)—the number that determines your son’s eligibility for need-based federal student aid—while typically up to 20 percent of the child’s assets may be considered.
  3. High contribution limits: 529 plans permit significant contributions, with many allowing $400,000 or more over an account’s lifetime. (Contribution limits vary by state and plan type.)  And based on the fact that in 2018 you can give an unlimited number of individuals $15,000 a year ($30,000 per couple) without reporting or tax requirements, a 529 account allows you to accelerate a tax-free lump sum contribution of up to $75,000 ($150,000 per couple) by electing to treat the gift as though it were spread evenly over five tax years.
  4. Flexibility: If your son receives a full scholarship or decides not to attend college, you can change the beneficiary to another family member, such as a sibling, stepsibling or even yourself. In addition, recent tax reform expands the reach of 529 plans: in addition to paying for higher education, states may now allow people to take up to $10,000 per year from a 529 account to pay for tuition at private or religious K-12 schools. On top of that, anyone can contribute, so a 529 presents a great opportunity for grandparents to support their grandchild’s future.

Custodial brokerage accounts

A custodial account is another option. This is an investment account in your son’s name that you set up and manage on his behalf until he reaches adulthood. One advantage is that it has fewer restrictions than a 529 plan. For example, you can make withdrawals at any time without penalty, so long as the money benefits the beneficiary, and there are no lifetime limits on contributions. The tax advantages, however, are few.

As with a 529, in 2018 you can contribute up to $15,000 ($30,000 per couple) to a custodial account without incurring the gift tax. But you’re only exempt from taxes on the first $1,050 of earnings per year. The next $1,050 to $2,100 is taxed at the child’s rate (often 10 percent—the lowest income tax bracket), and anything over $2,100 is taxed at the parents’ ordinary income tax rate. 

More important, a custodial account is an irrevocable gift, which means the money becomes your child’s property once he reaches your state’s “age of majority” (usually 18 or 21). So, it’s a bit of a risk: Your son may spend the money on college, as intended, or he could choose something completely different!

There's also a potential financial aid disadvantage. Because the accounts are considered a student asset, they’ll be factored into the EFC at the higher rate of 20%.

Don’t neglect retirement

Before saving anything for your child’s college, make sure you’re contributing the maximum to your 401(k) or other retirement accounts.

I recently read in a Sallie Mae report that 20 percent of parents who had retirement funds were planning to use them to pay for their children’s college, while another 19 percent said they would do so if necessary. I think this is a mistake for two reasons. First, you may be subject to taxes on the withdrawal, plus a 10 percent penalty. Worse, you might jeopardize your retirement.

As parents, it’s natural to want to put our children first. But you can use loans or other strategies to pay for your child’s education. You can’t get a loan for retirement. So, as important as college is, our retirement should always come first. Think of it as another way of taking care of our children, by ensuring we’re financially independent once we’re no longer working.

In any case, I encourage you to carefully review all of your options, keeping in mind what’s best for you and your son. And congratulations again for thinking about this now. By starting to save for your son’s education early, you’re giving him a gift that will last a lifetime.

Have a personal finance question? Email us at Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries,  contact Schwab.

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