Saving for Baby: Getting Your 529 Plan in Order

In this edition of "Bank of Dad" our columnist lays out what parents need to know about investment options for their baby.

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I’m a new dad. I have a 401(k), a nest egg, and some money set-aside for when, like, the boiler breaks. Now, my wife and I are expecting our first. So, how do I save for my baby? What are my options for saving? — Lawrence K., New Orleans

You’re smart to be thinking about college now. The average published cost of tuition is already $23,890 a year for out-of-state students, according to The College Board – and that’s at a public university. At the current rate of tuition hikes, you can imagine what that number will look like in 18 years.

Fortunately, there are a number of ways to start investing for higher education that can potentially save you a lot in taxes. Let’s break down the most common ones.

What Parents Should Know About 529 Plans

These state-administered plans have become the go-to vehicle for parents trying to build up their college savings, and for good reason. The money you put in accumulates earnings on a tax-deferred basis, and you don’t have to pay tax on money that you pull out for qualified education expenses. While the money you put into the accounts is taxable at the federal level, many states offer their own income tax breaks on contributions.

One of the perks of a 529 plan is flexibility — you don’t have to worry about income restrictions and there’s no cap on annual contributions. One potential downside is that your own state may not offer a great 529 plan, but feel free to explore other states’ plans if that is the case. Furthermore, you really want diversification in your account anyway, and many 529s offer index funds that don’t charge an arm and a leg in fees.

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What Parents Should Know About Coverdell Plans

Coverdell Education Savings Accounts – formerly known as Education IRAs – were once a popular way to prepare for the enormous costs of college. But when 529 plans came around, Coverdells starting losing a lot of their luster.

Yes, they offer the same tax-deferred growth and tax-free distributions as a 529. But you can only contribute up to $2,000 a year; given the soaring costs of a university education these days, that just doesn’t cut it for a lot of parents. Compare that to a 529, where each parent can kick in up to $15,000 a year and still be covered by the annual gift tax exclusion (you can put in even more, though each state has a limit on the total value of the account).

Plus, with a Coverdell, individuals have to make less than $110,000 (or $220,000, for joint tax filers), in order to contribute. You can see why these accounts are no longer part of the “in” crowd.

What Parents Should Know About UGMA/UTMA Accounts

Some parents choose to set up Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts for their children’s future education. Both are essentially trusts that put you – or a separate custodian of your choosing – in control of the assets until your son or daughter reaches adulthood.

There’s at least one important advantage of custodial accounts: you can invest in pretty much any securities you want, unlike a 529. But they don’t receive any special tax treatment when you use them for educational expenses. What’s more, custodial accounts have a bigger impact on financial aid packages than a 529. There’s also the fact that a kid can use a UTMA for whatever he or she wants when they are of age. So if an idea to quit school and hitchhike through Europe enters their mind instead, there’s no stopping them from burning through that money.

What Parents Should Know About Roth IRA Accounts

Normally, the earnings you pull out of a Roth IRA before age 59½ are subject to income taxes and a 10 percent penalty (you can always withdraw contributions to a Roth tax-free). However, the penalty is waived if the funds are used for qualified education expenses.

True as that may be, parents under 59½ don’t get the same tax benefit they would with, say, a 529, because they’re paying tax on the distributions. And pulling out your contributions can make it harder for your child to get need-based financial aid, so you have to be extra-careful when you withdraw money.

What Parents Should Know About Whole Life Insurance

Yet another option is to take out a whole life insurance policy and either withdraw or borrow against the cash value of the policy once your child heads off to college. The money isn’t counted against your child for financial aid reasons, and as long as you don’t pull out more than you’ve paid in premiums, it’s not subject to income tax.

But there’s a major knock on this approach, too. You get fairly mundane rates of return when you compare it the typical performance of a stock/bond mix over time. Unlike most investment accounts, there are also substantial upfront fees that eat away at your earnings potential.

And bear in mind that borrowing against your cash value reduces your death benefit, unless you pay it back. So while it might seem like a good way to pay for college, you could be eroding your family’s safety net in the process.

There are exceptions to every rule, of course, but you can see why the 529 is so popular. Certainly if you have unique financial circumstances, it won’t hurt to speak with a financial advisor and see if one of the alternative routes makes sense.

I have a 529 account for my daughter and realize I don’t know what I can do with it? I’ve been told they’re more versatile than I think. How can I capitalize on that versatility? — Jason C., Utica, New York

Indeed you can, thanks to the big tax law that Trump signed in late 2017. Now, you can use up to $10,000 of money in a 529 account to pay not just for college but also private primary and secondary tuition.

A word of warning, though: These investment plans are run by states, not the federal government. And as of November, 17 of them hadn’t updated their laws to comply with the tax bill.

What does that mean exactly? If you’re in one of those 17 states, it’s possible that your withdrawal for K-12 tuition could trigger state income taxes. Needless to say, you’ll want to do a little research to understand the potential impacts.

For everyone else, 529s are a pretty sensible way to help defray the cost of a private education, including the purchase of books and computers. Your money grows on a tax-deferred basis and bypasses the IRS as long as it’s used for qualified expenses.

You don’t necessarily have to put money in the account for very long to reap important benefits. Because most states offer a tax deduction for contributions, you can lower your tax bill even if you pull money out shortly after it went in.

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