What’s the best way to save for college
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With the cost of college education increasing year by year, many parents plan to pay for part of their child’s college education with the money they saved, and then fund the rest with student loans, grants, or grants. scholarships.
Yet most parents end up saving less than they plan on. According to the Education Data Initiative, on average, parents expect to pay about 30% of their child’s college expenses, but end up paying only 10%. If you want to avoid this common pitfall, it is essential to start investing early and choosing the right investment vehicle.
Select spoke with Mark Kantrowitz, higher education expert and author of How to Appeal for More College Financial Aid, about whether parents should opt for a 529 plan, brokerage account, or Roth IRA when saving for the ‘university.
The pros and cons of a 529 account
A 529 Savings Plan, which takes its name from the tax code, is the perfect option to invest for college because of the tax benefits it offers. These state-sponsored investment accounts give people the option to invest in different stock or bond funds, and you won’t pay tax on your investment earnings or when you cash in to pay out. qualified education expenses such as tuition, board and lodging, supplies.
Some states even consider 529 dues to be tax deductible and some give parents a head start in investing for college – New York, for example, gives all public school students $ 100 that is invested. in a savings account 529.
While 529 savings plans have a wide range of benefits, there are a few drawbacks. The money you invest in a 529 should be used for education costs. If not, you will have to pay a penalty of 10% plus income tax on your withdrawals.
There are exceptions to this. You won’t have to pay the penalty fee if your child receives a scholarship or attends a U.S. military academy, says Kantrowitz. So if your child gets a scholarship, you can access the money you saved without having to pay a penalty.
The Pros and Cons of a Roth IRA
Another investment vehicle to consider is a Roth IRA. According to Kantrowitz, a 529 savings plan and a Roth have a lot in common: You won’t be taxed on your investment earnings, and you will be able to make qualifying withdrawals tax-free.
A Roth IRA is typically used as a retirement account, so there are limits on how and when you can use the money. When you withdraw the investment gains from your Roth IRA before you are 59 and a half, you must pay a 10% penalty. If, however, you’ve had a Roth IRA for more than five years and you use the withdrawal for qualifying education expenses, such as tuition, fees, books, and supplies, you won’t have to. pay penalty or income tax.
And if your kid isn’t going to college, you can still use the money for other things, like your own retirement, or even save it so your kid has a good head start on their own savings. -retirement.
The pros and cons of a brokerage account
Brokerage accounts also offer flexibility that 529 savings plans do not. While the money you withdraw from a 529 or Roth IRA plan is to be used for qualifying expenses, you can really do whatever you want with the money you invest in a brokerage.
You might also be tempted to use a brokerage account as it gives you more investment options. You can invest your money in individual stocks, bonds as well as index funds. With 529 savings plans, individuals can usually only choose between a few different equity and bond funds.
There is one major downside to investing your college savings in a brokerage account: the long-term capital gains tax. You could pay up to 20% depending on your tax bracket, says Kantrowitz. That $ 100,000 that you put in for college in a brokerage account might end up being just $ 85,000 after paying taxes on it.
Why a 529 Savings Plan is Better than a Brokerage Account or a Roth IRA (Most of the Time)
Whichever investment vehicle you choose, it’s important to understand the impact your college savings could have on your FAFSA application and your expected family contribution (CEF).
Your CFE is a number used by colleges to determine the amount of financial aid you are eligible for.
You can think of it like this: Colleges decide on a cost of attendance (this usually includes tuition, room and board, as well as books and supplies), then subtract the CFE from the cost of the course. attendance to determine how much financial aid your child is. have the required qualifications for. So if your family has a higher CFE, your child will be eligible for lower aid based on state and federal and institutional needs.
There are a number of factors that go into determining your CEF, but the most important factors are student income and parent income. A parent’s property and a student’s property, on the other hand, are not weighed as heavily. The accounts are also weighted differently depending on whether the child or the parent is considered the owner.
In other words, using certain types of investment accounts to save for college can increase your CEF and decrease the amount of help a child receives because some investment accounts are reported as assets. while others are reported as income.
A 529 savings plan is considered a parent asset, so the amount saved in it only reduces eligibility for assistance by up to 5.64%. For example, if you invested $ 100,000 in a 529 plan, your eligibility for assistance will be reduced to $ 5,640.
While this may seem like a lot of money, consider that a distribution from your Roth IRA could reduce your eligibility for need-based assistance to half the amount of the distribution, as it is reported as income and not as an asset, explains Kantrowitz.
So if you decide to plunder your retirement savings and use $ 100,000 from your Roth IRA to fund your child’s education, you could end up reducing your eligibility for assistance down to $ 50,000, because the Money withdrawn from a Roth IRA is considered parental income. (The value of your IRAs or 401 (k) s is not calculated in your EFC if you do not withdraw money from them.)
For a taxable brokerage account, the reduction in eligibility for assistance depends on the name of the account. If the brokerage account is in the child’s name, it is considered a student asset and will reduce eligibility using 20% of the equity in the account. If the brokerage account is in the parent’s name, it will reduce eligibility for assistance by up to 5.64% of the account value, as it is considered an asset of the parent, Kantrowitz explains.
Overall, a 529 savings plan is the best option for investing for college, but there are still a few exceptions.
“A family may not want to save in a 529 plan if there are serious doubts about whether the child will go to college, whether the parents want a wider range of investment options, or whether the family expects to have to spend money on non-qualifying expenses, ”says Kantrowitz.
If you’re looking to get a 529 brokerage account and savings plan, check out the options offered by Wealthfront, which offers individual retirement accounts, robo-advisers, and 529 savings plans.
If you’re just looking for an IRA, consider a Schwab IRA, Fidelity Investments IRA, or Vanguard IRA (see our full list of the best Roth IRAs). And if you’d rather take Route 529, check out Select’s roundup of the best 529 plans.
Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.