The Millennial Parent’s Guide to College Savings Accounts

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Student loan debt is a major financial strain on many young adults. The average Class of 2016 grad owes over $37,000 in education debt and collectively, Americans are in hock to student loan lenders to the tune of $1.4 trillion.

Among Credit Sesame’s more than 8 million members, about 500,000 of those aged 18 to 34 owe $10.5 billion in student loan debt. Around 41 percent of that is owed by older Millennials, aged 25 to 34, who carry an average loan balance of $21,000.

For most of us, student loan debt makes it harder to reach other financial goals. For example, you may want to buy a home but a big student loan payment is an obstacle to saving money for a down payment, qualifying for a loan with a healthy debt-to-income ratio and affording the monthly costs of homeownership in general.

College savings for your child

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If you’re thinking of having kids of your own someday, or you’re already a parent, helping your children to avoid student loan debt may already weigh heavily on your mind. According to a recent TD Ameritrade survey, 19 percent of millennial moms and dads say saving for their child’s future education costs is a top financial priority.

Some of those parents said they were already saving for their child’s college years, socking away $310 a month on average. Saving for retirement ranked third on their list of top financial goals, after saving for their child’s education and building an emergency fund.

An early start on college savings for your child could make a world of difference in how much financial burden you’ll endure later, as well as how much your child might have to borrow. A financial independence survey conducted by Credit Sesame found that 78 percent of members with a credit score of 750 or higher have already gotten a jump on saving.

Where’s the best place to keep the money you’re squirreling away?

Save for college tax-free with a 529 plan

A 529 account is one of the most common—and most popular—college savings options. These plans saw record gains in 2016, with total assets reaching $275.1 billion.

529 savings plans vs. prepaid tuition plans

529 accounts take two different forms: college savings accounts and prepaid tuition plans. College savings accounts are more common. With this type of account, you can make contributions for a qualified beneficiary, which could be your child, your spouse, another family member or even yourself.

The money you save in a 529 savings account is meant to be used for future college expenses. The amount you can save in one of these plans varies from state to state. You don’t have to be a resident of a particular state to save in their plan. You’re also not restricted to any particular school, so long as it is a college, university, vocational school, or other post-secondary institute recognized by the Department of Education.

Prepaid tuition plans work a little differently. With this type of 529 account, you essentially lock in your child’s future tuition costs. You pay for your child’s tuition costs in advance, only instead of paying whatever the going rate is when he or she goes to college, you pay today’s price.

Why use a 529?

The primary draw of 529 plans is the tax advantage they offer. As long as the money you save in a 529 is used for qualified education expenses, earnings and withdrawals are tax-free.

What are qualified education expenses?

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The Internal Revenue Service has specific guidelines concerning what constitutes a qualified education expense. That includes:

  • Tuition and fees
  • Books, supplies and equipment
  • Expenses related to required special needs services
  • Room and board expenses for students who are enrolled at least half-time
  • Computer equipment, software and internet access if your child is using it primarily while they’re enrolled in school

These expenses are covered at eligible educational institutions: any college, university, vocational school, or other post-secondary institute recognized by the Department of Education and eligible to participate in federal aid programs. Your child doesn’t have to receive student aid, however, to use 529 account funds to cover costs.

Watch out for penalties that apply when you use 529 withdrawals to pay for expenses that don’t qualify. You’ll pay a 10 percent federal tax penalty, plus ordinary income tax on the amount you withdraw.

Supplement savings with a Coverdell account

A Coverdell Education Savings Account is another option for socking away money for your child’s future expenses. These accounts have a few more rules and one distinct advantage over 529s.

First, Coverdell eligibility is based on income. As of 2017, you can contribute to a Coverdell if your modified adjusted gross income is less than $110,000 for single taxpayers or $220,000 for married taxpayers filing a joint return. By comparison, anyone can save in a 529 account.

Coverdell accounts limit annual contributions. In 2017, the most you can chip into a Coverdell account is $2,000 per child. That may be fine if you don’t have a lot of money to save. If you’re able to stash away more than that each year, 529 accounts generally have higher contribution limits.

Once your child turns 18, you can’t add any additional funds to a Coverdell. In contrast, you can keep contributing indefinitely to a 529.

Another key difference between Coverdell accounts and 529 plans are the guidelines for using the money. Withdrawals for qualified education expenses are still tax-free but with a Coverdell, your child has to use all the money in the account by age 30. If you don’t use the assets in the account by then, or transfer them to another family member, the IRS can hit you with a 50 percent tax penalty for failing to withdraw the funds in time.

The same rule applies for distributions (withdrawals) for non-qualified expenses. You’ll owe a 10 percent penalty, plus income tax on Coverdell funds that are used for expenses other than college.

One clear advantage of Coverdell accounts – they can be used for education expenses before your child goes to college. Distributions may be used to pay for qualified higher education expenses or qualified elementary and secondary education expenses. That includes private and religious schools as well as the post-secondary institutions mentioned above for 529s.

Roth IRAs can double as a college savings account

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If you’re already saving for retirement, you may have a ready option for college savings. A Roth Individual Retirement Account can be used to pay for your child’s college costs. The annual contribution limit for these plans is set at $5,500 for 2017.

In retirement, you can make withdrawals from a Roth IRA completely tax-free, but the guidelines are a little different if you’re using the money for college. You can withdraw your original contributions without any taxes or penalties at any time, for any reason, if the account has been open for at least five years. You can withdraw earnings penalty-free for college expenses, but you’ll pay income taxes on gains.

There are some advantages to using a Roth IRA to save for college, instead of a 529 account.

  • You may find a broader range of investment choices. Some 529 plans only offer a few mutual funds to investors, so a Roth might be better if you want for more variety.
  • With a 529 plan, you can only change your current investment allocations twice per calendar year. A Roth IRA doesn’t restrict you in that way.
  • If your child doesn’t need all of the funds for college, you can keep growing your Roth without any added hassles. Leftover 529 plan money must be rolled over to another beneficiary or the withdrawals are subject to taxes and penalties.

The one significant argument against taking Roth funds out to pay for college is that you can shortchange your own retirement by doing so. If you’ve already pushed retirement to the backburner in favor of saving for college, consider the financial consequences to raiding this fund.

Keep it simple with savings accounts and CDs

529 plans, Coverdell accounts and Roth IRAs have one thing in common: funds are usually invested in mutual funds or stocks. Investing in the stock market can lead to bigger returns but it also involves more financial risk.

If you’d rather play it safe, an online savings account or a certificate of deposit may be a better fit. With these accounts, you will earn less over time, but you don’t have to worry about losing money either. You can use the money for college-related expenses, or anything else you might need to cover, like helping your child buy a car or outfitting his first apartment. If you’re a Credit Sesame member, you can log in to your account and check your dashboard for personalized banking recommendations.

Savings accounts and CDs do have limits on how you can access your money. On a savings account, the limit is six withdrawals per month under federal Regulation D. If you withdraw funds more often, your bank could charge you an excess withdrawal fee, or convert your savings account to a checking account (and you’ll earn less).

Withdrawals from a CD are determined by the maturity date. For example, if you invest in a five-year CD, you will need to wait five years before withdrawing the principal and any interest you’ve earned. If you withdraw money from a CD ahead of schedule, you may have to pay a penalty to the bank. This penalty is usually a percentage of the interest earned. You can set up a CD ladder to earn the best rates and gain more frequent access to funds.

Getting your college savings plan started

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If you want to start saving now for your child’s future college costs, make a plan.

Reexamine your budget. Look at your fixed monthly expenses and your discretionary spending (eating out, entertainment, clothing and so on). Factor in any debt payments and regular contributions to your own savings.

Compare the total to your net income to see how much money is available to devote to college savings.

The beauty of long-term savings is the value of time. Even small amounts add up if you save consistently and leave the money in the account.

Let’s say you’re 30 years old and you have a two-year-old daughter. You can afford to save $100 a month in a 529 account. If you save that amount for the next 16 years and earn an average annual return of 7 percent, you’ll have over $35,000 in the account by the time she’s ready for school. That may not cover the total bill for college but every penny counts, especially if you’re trying to save your child the pain and burden of student loan debt.

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Published September 1, 2017 Updated: August 31, 2017
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