The rising costs of educating a child in today’s world are a concern for young parents across the country. Faced with the choice of taking on debt to help with a college tuition, sacrificing your own investments, or burdening your child with debt before they even enter the workforce, it can be a frustrating and expensive problem for a family to plan for.
In a 2014 article for Bloomberg, Michelle Jamrisko and Ilan Kolet found that college tuitions increased 1,225% from 1976 to 2014. Many parents have responded to these increases by putting their children in private schools before college, hoping it will lead to scholarships that would defray college tuition costs. But private elementary and high schools don’t come cheap either; so what options does a parent have who wants to set aside funds for their child’s education? Let’s look through some commonly used options:
UGMA/UTMA accounts: a Uniform Gifts or Uniform Transfer to Minor Account is a tool that provides flexible planning options for schooling. There is no limit on how much you can contribute annually, and the funds held inside of these accounts must be used for the benefit of your minor child. Unlike 529s, which must be used for college expenses, UGMAs and UTMAs can be used for anything benefitting the child, which makes them an attractive tool for parents looking for investments that can help with private school tuition before college. However, the lack of restrictions placed on these funds also can scare off many parents. Once your child reaches 18, the money in their UGMA or UTMA is theirs to control, and the parents have no say in how those funds are used. If you’re raising some mature, forward-thinking children, this may be of no concern to you. But if you think your kid might turn 18 and blow through that money in a week, an UGMA may not be the best option for you.
529 Plans: one of the more tax-efficient tools for education savings, funds in 529s are specifically for college-related expenses: Money invested in these accounts grows tax deferred, and funds can be withdrawn free of taxes if they’re used for qualified college expense such as tuition or room and board. If funds are withdrawn for unqualified reasons, the account holder must pay a 10% penalty along with ordinary income taxes. While the contribution limits ($250,000 per beneficiary) are much higher than an education account such as a Coverdell, it is subject to gifting taxes.
Coverdell Savings Account: the Coverdell can be seen as a hybrid between a 529 and the UGMA/UTMA accounts. Similar to the UGMA/UTMA, It allows you to put aside money for more than just college expenses, but like the 529, the funds are designated for schooling. Coverdells can help pay for a child’s qualified school expenses from kindergarten all the way through college. Earnings are tax deferred until they’re withdrawn, and tax-free if used for qualified expenses. Contributions are capped at $2,000 a year, a low amount relative to the other options listed. Because of this limit, it’s best to start funding them early if you plan on using a Coverdell extensively. With some private schools charging tens of thousands of dollars in tuition, the account’s effectiveness can be limited if not planned for properly.
Mutual funds and cashflow: while they carry none of the education benefits reserved for the other accounts listed, using mutual funds or monthly cashflow to fund education expenses can be the best option for some families. For example, if your child gets to college and, because of scholarships or other reasons, doesn’t need all of the funds in their 529 account, you now have a pool of money you can’t access without paying a 10% penalty. Conversely, if you’ve been paying for private schooling since your child was in kindergarten out of your monthly cashflow, you may find that their college tuition is a similar expense. This played out in my life, as the private high school I attended-and my parents paid for using their monthly cash flow-was actually more expensive than the college I attended. Since they could afford to cashflow it then, putting money in an education account that could be invested in their retirement accounts or other investments might not have been the best option for their future.
Permanent life insurance: while you've likely seen plans such as the Gerber plan, where you put permanent life insurance on your child with the intention of using the cash value to pay for college, these are often very limited in terms of the amount of money you can contribute. Permanent life insurance is a complex topic, but here are a couple features of permanent life insurance that will help you understand the limitations of placing insurance on a child: permanent life insurance has many components that factor into how much you pay. Two of those components are the actual cost to the insurance company that you (or in this case, your child) might die, but these policies also allow a portion of your premiums to be deposited into a cash value account. That account is invested, and if you meet certain stipulations, a portion of that money can be accessed free of income tax in later years. Because of the tax favorability, people turn to permanent insurance for things such as retirement and college planning. BUT, the IRS will limit how much you can put into these policies each year to prevent people from turning an insurance policy into a tax-shelter for the wealthy. By putting the insurance coverage on your child, you're limiting how much you can contribute because the cost of insuring a minor is low. However, if you're interested in using this as a strategy, by putting the coverage on yourself, you will likely be able to contribute more money each year, hopefully leading to more funds you can use for your children's schooling. I would strongly advise you to engage a financial advisor if you're considering this strategy; it can be a great tool when used well, but understanding if it's a fit for you can be tough without some help.
The great thing about all of the options listed is you aren’t forced to choose one over the other. Review your financial plan and see if you can use multiple accounts to fund your child’s education, or if one account suits your needs. Thinking about the need is the first step, and the earlier you plan, the more prepared you will be when the time comes.
The information presented is not intended as tax, legal or financial advice, and you are encouraged to seek such advice from your professional advisors. The content is derived from sources believed to be accurate.