What’s The Best Way To Save For College?

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If you have kids, a topic that’s bound to come up at some point is college.  Along with either the sad and/or giddy thought of finally sending your kids off to college is also the worrisome thought of how are they/you going to pay for it.  If you currently have a baby or a toddler, the cost of college is projected to be anywhere from $200,000 for a 4 year in-state public university to $500,000 for a 4 year private university like a Harvard or Yale.  If you don’t want little Emma or Ethan to come out $200,000 to $500,000 in debt, you probably want to start a college savings account of some kind.  But remember, that saving for retirement should be a higher priority over saving for college.  It’s harder to make up the deficit in retirement savings whereas your kids are likely to have more options to pay for college (e.g. financial aid, scholarships, work study programs, etc).  Also, you always have the option of using some of your retirement savings to supplement paying for college as we’ll discuss a little below.

But what is the best way to save for college?  Let’s go through four common options to see if one’s best for you.

529 Plan: Probably the easiest and most straightforward way to save for college for the majority of families, especially if you are in a higher income tax bracket.  It is an educational savings plan sponsored by a state or state agency that allows the money you contribute to grow tax-free and later withdrawn tax-free if used for qualified higher education expenses.  Some examples of covered expenses are tuition & fees, required books, supplies and equipment and recently computers.  Individual states may also offer a state income tax deduction if you contribute to their state plan, which translates into more savings for you.  Their are no income limits and maximum lifetime contribution limits are high, depending on the plan roughly $250,000 to $400,000.

Coverdell Education Savings Account (ESA):  A limited way to save for college in my opinion due to its contribution limit of $2000 per year total per beneficiary (all sources) and income cap with a modified adjusted gross income (MAGI) of $220,000 for joint filers and $110,000 for single filers.  This effectively means those of us with higher incomes like the upper end of the 28% tax bracket and above can’t even contribute to an ESA.  A supposed workaround is to gift the money to your child and open it that way, but this will count against your child’s financial aid as it will be considered their assets.  The money in an ESA also grows tax-free and can be withdrawn tax-free if used for educational purposes just like a 529.  The main difference and advantage over a 529 is that the funds in an ESA can be used for K-12 schools, both public and private.  Additionally, ESA’s have more investment options compared to a 529, for those investors out there who have very specific tastes in investments and aren’t happy with the limited funds and age-based options that most 529’s offer.

I think the biggest perk of an ESA is the ability to use its funds for qualified expenses for K-12 education such as private school tuition and fees, both private and public school books, supplies, and equipment, academic tutoring, special needs services for a special needs child and after-school care.  It could also be used to purchase computers and internet access though not for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature.   This is straight from the IRS website.

Whole Life Insurance: Whole life insurance is a kind of permanent life insurance that has a cash value attached to it and last throughout a person’s life.  Along with a cash value it also comes with a lot of fees and high premiums too.  Lately though I’ve been hearing of more families using this method as a way to save for college.  The pitch I’ve heard from an insurance salesman tries to point out the flaws of a 529 to highlight whole life insurance as the better college savings vehicle.

-What if your child decides not to go to college or grad school, you’ll be hit with taxes and a 10% penalty to withdraw the funds in a 529.  You actually only pay taxes and the 10% penalty on the earnings portion of the 529 if it is not used for qualified higher education expenses.  You can also easily roll over a 529 account to a sibling or any relative including a niece or nephew or even to yourself or your spouse without penalty.  However, if this is truly a concern and you only have one kid, then consider using a Roth IRA instead to save for college (see below). 

-Did you know 529’s count against your child’s financial aid, but not whole life insurance?  It does, but 529’s are considered parental assets and therefore do not affect financial aid calculations as much as if it were considered a student’s own assets.  The way money is taken out from a whole life insurance policy can end up being considered a student’s income and count against financial aid as well, so it’s not a guarantee that whole life insurance does not count against financial aid calculations.

-Some schools don’t qualify for 529 plans.  Also, what if they want to go to a school outside the US, like Oxford?  This was somewhat true a long time ago when 529’s were first introduced.  Now almost all accredited schools will qualify, including vocational schools and trade schools as well as some foreign schools too.  You can check out if the school qualifies here as SavingForCollege.  But come on, is your kid really going to be the one kid that decides (s)he is going to some esoteric college in Greenland?

-Only qualified higher education expenses are covered by a 529, but you can use whole life insurance cash value for anything!  You can use 529 funds to cover qualified higher education expenses and money invested from a taxable account that will most likely have a higher return than a whole life policy for anything too!  

All valid points and addressed above in italics.  There are many drawbacks to whole life insurance policies behind the shiny presentations.  They carry high fees and premiums as in thousands of dollars per year that make it costly for the average person to keep up with for 18 years, even for those of us in the top 5-10% of household incomes.  Because it takes almost 10 years or even more before a whole life insurance policy makes positive returns, if you stop making the premium payments before then, you might end up with nothing or very little in the cash value.  It also tends to be a very complicated product with tons of fine print to read making it a difficult product for most consumers to understand.  Even more complicated are the newer index universal life insurance (IUL) and variable universal life insurance (VUL) policies.  If you don’t believe me try going to a life insurance company’s website and take a look at the prospectus on a whole life insurance policy and you’ll see what I mean.  Here’s one from Transamerica Life.  It’s only about a 100 pages long.  Lastly, think about the huge conflict of interest an insurance salesman has to sell you one whether it’s a good idea for you or not, since they make commissions of around 50% of your first year premiums and possibly more.  There’s a reason why life insurance companies are willing to pay such huge commissions, because they make a lot more off of you.  The bottom line about using whole life insurance as a college savings fund is that it’s probably a bad idea for MOST people.  Not all.  Most.  So for whom can it be a good idea?  Rich people who are very risk averse.  I’m talking about people who make at least $500,000 or more, the 1%.  Why risk averse rich people?  Because rich people have a lot of money and can afford to make expensive premium payments for 10 years+ with little risk of defaulting and because they can afford to make mistakes with their money, because hey they are rich.  Risk averse because most whole life insurance policies only make about a 4% return over a long period of time compared to historic stock market return rates of 6-8% over the long term.  But with a whole life policy you’re very likely to get the 4% as long as you can keep the policy going for 10 years+.  With the stock market, if your kid happens to start college when the stock market tanks, like it did in 2008, then you might lose a significant portion of the balance.

Roth IRA:  Probably wouldn’t have thought of using good ole Roth for saving for college but you can.  It’s main draw over a 529 account as a college savings plan is in it’s flexibility.   If your kid decides not to go to college or gets a full scholarship then you can keep the money and save it for retirement instead without having to pay a penalty and taxes to withdraw the earnings.  There’s some conflicting information about whether a Roth IRA counts against your child’s financial aid, since a parent’s retirement assets are not reported on a FAFSA but the distributions from a Roth IRA used to pay for college expenses may end up being considered a child’s income which would end up counting against your child’s financial aid.  So keep that in mind and maybe consult a financial aid specialist.  I’d say if you only have one kid and you feel iffy about whether they’ll go to college, then maybe a Roth IRA as a college savings fund isn’t such a bad idea.  It works similarly to a 529, you contribute after-tax money (but no state deduction) and the money grows tax free and you can withdraw the money penalty free (but not tax free) if used for qualified higher education expenses.  The other option would be to use the contribution portion of the Roth IRA only (and not the earnings portion) since you can withdraw that at any time without penalty or taxes.  The contribution limit for 2016 is $5500, but that’s per parent, so if both parents contribute to a Roth IRA, then that’s $11,000 per year.  Assuming you are able to save $11,000 x 18 years, that would create a principle portion of $198,000 to use for college.  It’s probably not enough to cover all expenses for college, but it’s a considerable sum.  But obviously this works best if you have one kid.  If you have 2 or more, then that $198,000 is going to be halved or thirded.  Is that a word?  There are also income limits on a Roth IRA, MAGI of $184,000 for 2016 (for married filing jointly).  From $184,000 to $194,000 you can contribute a prorated amount only.  However, there are no income limits on a Roth conversion, so you can contribute to a Roth IRA via the “backdoor” by opening a traditional non-deductible IRA then converting it to a Roth if your income is too high.

Other than the limited amount you can save for college, the major reason I wouldn’t advise using a Roth IRA for college savings is because the Roth IRA is too valuable as part of a retirement strategy.  Roth IRA’s generally become more valuable with time since the funds inside compound and grow tax free and can later be withdrawn completely tax free in retirement.  A tax free source of income can be a very important tax diversification strategy in retirement and the Roth IRA is the only account that offers this advantage (and a Roth 401k if you have access to one and maybe cash value life insurance).  Ideally, if you can, you should be maxing out both your employer sponsored retirement account like a 401k or 403b and a Roth IRA.  That way if you do fall short on college funds, then at least you have the option of pulling some money from the Roth IRA if necessary, but this should be a last resort.

So what’s the best way to save for college?  While there’s no one right answer for everyone’s situation, most high income earners that fall into the 28% tax bracket and above will probably be best served by using a 529 savings plan.  A 529 plan is simple and straightforward, created specifically to help families save for college.  If you live in a state that offers a tax deduction, it benefits you even more.  If you want a little more flexibility then consider using combinations of the options above such as 529 + Roth IRA or Roth IRA + ESA.  Don’t forget you can also just use a good old taxable account to save as well.

While creating a college savings fund for your child is an invaluable gift, don’t forget to also teach them about the value of the gift they are receiving, since sadly it seems that many college students have no idea what it costs to have the privilege of obtaining a higher education.  My husband and I are planning on ideally saving around 50-75% of college costs for each of our children and then planning on making our children cover the other 25-50%, through financial aid, hopefully some scholarships and/or good old fashion work.  Hopefully this will teach them the value of a dollar and that money doesn’t grow on trees.  As they say, catch a fish for a man and he’ll eat for one day, teach a man how to fish and he’ll eat for a lifetime.

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