Education is one of the most important rights for people. Yet, these costs are steadily rising. This is due to different factors like increasing inflation rates, federal and state income tax rates, etc.
In fact, the cost of tuition fees in private and public colleges in the US has inclined heavily in the 2022-2023 period alone, compared to previous years. Reportedly, private colleges have seen a 4% increase in average fees in the 2022-2023 academic year. Public schools saw a 1% increase for out-of-state students and a 0.8% increase in average tuition costs for in-state students.
Without a doubt, such fluctuations in the cost of education are common. You should continue to factor that in when making financial decisions. But when should you start worrying about tuition, college savings, etc.?
The correct answer is to start planning for your child as soon as possible. Here, we will discuss your present investment choices.
What is the importance of investing in children's education?
The first question for people is, of course, why investing in college savings sooner is necessary in the first place. The fundamental answer to the query is to improve your children's future early on by creating proper financial stability.
To note, different programs and policies for children to get started at a young age. These programs target social-emotional, cognitive, and linguistic development for kids for growth in their future academic lives and careers. So, focusing on increasing the education savings for children sooner with such programs will benefit them in the long run.
Proper training makes it easier for people to get the right kind of employment. The lack of work opportunities can lead people to depend on grants, tax benefits, and even personal loans for college expenses. But these are only suitable for short-term life sustenance.
For example, you risk falling into debt if you do not pay off your loan amounts on time as planned. You must consider debt relief options to stabilize your finances, which will also become challenging to manage without a stable job.
Good employment opportunities are a significant concern for people. Getting the proper schooling makes it possible for people to aim for higher-paying jobs. Finding suitable investment types for college savings sooner is helpful so that children can pursue their chosen training course. From a long-term perspective, investing early in education savings benefits children.
Types of investments available for child’s education
Currently, there are different investment options for managing college savings for children early.
Some of these methods, like the 529 plan, are good preset education savings plans for children's future education. Others, like Roth IRAs or exchange-traded funds, are not traditional college savings plans. But they are valuable options for education savings.
Here, we discuss each type.
Conventional investment types to save money for children's future education.
There are programs for financial aid from the government and private corporations, like a 529 plan, custodial trust account, or ESA. The main features of these college savings plans vary in terms of features, eligibility, and federal/state tax laws.
529 Plans
A 529 college savings plan is a tax-advantaged savings account for in-state students who want qualified education expenses. People can activate a 529 plan for their children or grandchildren, adding the young recipient as the account beneficiary. The child can later use their 529 plan funding to pay for college-related costs, like books, tuition, fees, room and boarding costs, etc.
The 529 plans with saved funds grow with time without tax deductions. The account beneficiary can later access the account and make tax-free withdrawals. It is important to note that some states offer certain tax deductions on any contributions to the 529 plan.
The types include:
Type 1: Education savings plans-
These include programs that cover many investment options that a person can invest in for college savings. Parents that open this type of 529 plan for their children contribute money into accepted asset types for investment. The saved amount grows with time until the child reaches college-going age.
Plus, some people activate target-date funds into their chosen 529 plan to adjust the assets within the account automatically.
Type 2: Prepaid tuition plans-
Specific educational institutions approve students to apply for prepaid tuition for courses within their premises, which also falls under the 529 plan category. The program activates after the child is born, and the current tuition rate locks in for the prepaid tuition plan. The fixed-rate does not shift due to external factors like inflation. Thus, the account grows consistently until the child reaches the age of maturity.
Features of 529 plans:
- The eligibility rules and high contribution limits vary for different states. It is best to take the help of accredited in-state financial advisors or brokers for the right 529 college savings plan. Then, they will help buy a 529 plan for your child.
- The 529 college savings plan works for saving up for K-12 education costs at elementary and secondary schools. There are no age or yearly contribution limits in place here.
- An annual gift tax exclusion is applicable under the Internal Revenue Code. People must pay around $17,000 as federal gift tax on these 529 plans 2023.
- People can use the saved money in their 529 plan for reasons unrelated to training or education. They will fall under the non-qualified withdrawal category and incur a 10% penalty rate.
- State tax and federal income taxes do not apply to the withdrawals and growth in the 529 plans otherwise.
Coverdell Education Savings Accounts
The Coverdell Education Savings Account is a custodial account or trust that is also useful for early education savings. Parents or grandparents can set up this savings account type for their young dependents and name them the beneficiaries.
But, unlike 529 plans, contribution and income restrictions exist in the Coverdell ESA accounts.
Features of ESA plans:
- The ESA account holder has to limit their contributions to $2,000 per year for each child with this plan.
- The beneficiary must use the money saved in the account by the age of 30 years. Otherwise, the money goes to another assigned family member for college expenses without penalties or state taxes.
- There is no non-qualified withdrawal regulation with ESA plans.
- Income restrictions exist for the account owner with these accounts, unlike with 529 plans.
- Single filers of the ESA plan cannot make contributions if their modified adjusted gross income or MAGI is over $110,000 in 2023. For joint filers, the income limit is set at $220,000.
UGMA/UTMA Accounts
Custodial accounts are another good option for people to invest in their children's education. Two notable custodial trust accounts include UTMA (Uniform Transfer to Minors Act) and UGMA (Uniform Gift to Minors Act) accounts.
Parents or family members can activate this account type and manage it as their child’s account custodian until they turn of age.
On average, 18-25 years is set as the expected time of maturity for these trust accounts, varying from state to state. Before this period, the account custodian in charge of the account can make their contributions. They can invest the saved funds into investment securities like mutual funds, bonds, and stocks to grow the account balance over time.
The custodial trust accounts have more flexibility than education savings plans like a 529 plan. For example, any family member can contribute to these custodial trust accounts. The child can use the money for non-educational reasons, like buying a home or car. But, unlike 529 plans, these accounts have less tax benefits.
Non-conventional investment types to save money for children's future education.
People can use one or a group of different asset classes to meet their investment objectives for qualified education expenses.
Here are some of the most commonly used ones.
Brokerage Accounts
Professional brokers also create brokerage accounts for children, specifically teenagers. As a medium of paying qualified expenses, this is a suitable option. The accounts come with minimal fees and are ideal for long-term investment.
With this account, people can invest in asset classes like stocks, mutual funds, bonds, and ETFs. Putting aside some for your child's future expenses is an excellent way to fund education expenses later. Plus, you can inform children about the legalities and features of the investment vehicles, too.
The brokerage accounts do not come with tax benefits for the account owner. Children learn to manage their financial condition with more control when they own a brokerage account.
Roth IRAs
Roth IRAs are inherently retirement accounts. But people can use them to save up for children's education. The account owner can access the accumulated money after around five years. Later, you can get out account distributions without penalty for qualified education expenses.
How do Roth IRAs help with education savings?
An account owner for a Roth IRA can use it for investing their money after tax deduction and save their earnings from more taxes. But they need to make proper distributions first, like with a normal 529 plan. As for children, they can use Roth IRAs for qualified education expenses without complex steps. This is especially so if you activate automated investment as a robo-advisor.
If your child does not follow through with college, the money saved in the Roth IRA account still grows well enough for retirement.
Grants and Scholarships
Scholarships and grants exist for younger people to contribute to their college education expenses from Federal Student Aid (FSA). The criteria for application, state tax deduction, and related factors differ as corporations, foundations, and colleges offer these scholarships for financial aid.
The grants and scholarships apply to people applying for needs-based programs only after getting the FAFSA or Free Application for Federal Student Aid. The deadlines are different state by state. Thus, following the regulations for Federal Student Aid specific to your region for obtaining the proper federal and state grants is essential.
Types of instruments for 529 savings plans- Which investment options are available?
People can invest in some investment instruments for their college savings plans. These types usually are not used for saving college funds. But, under a 529 plan, people can use these mediums to invest money and then slowly grow that amount for their child’s future education.
Exchange-traded Funds
ETFs or Exchange Traded Funds include a diversified investment portfolio of several investment instruments, like bonds, stocks, etc. Unlike similar options, like mutual funds, the trading occurs in stock market exchanges at regular hours. So, someone like a brokerage account owner can depend on ETFs for quick trading.
The ETFs are cheaper in cost since they are index funds, even actively managed ones. It is possible to view the holdings within the ETF at any time.
Savings Bonds
People can digitally buy savings bonds from TreasuryDirect.gov and use them for financial aid. Later, the account owner can redeem the saved amount within restrictions and use it for qualified higher education expenses. If you do not use the funding for accommodation, it is also possible to exclude it from any tax deduction.
Regarding the pros and cons of using these bonds for college savings, the former is the low-risk factor. On the other hand, the con is that account holders get low interest rates on their earnings.
Mutual Funds
A mutual fund is an investment vehicle type that people can opt for in their college savings plan. Many investors pool their money into the vehicle, which is later invested into a diversified investment portfolio, including asset classes like bonds, stocks, etc. People can later use these funds for their children's college education, but mutual funds are subject to tax deductions. So, it is a risky investment option.
Tuition-assistance programs
People can apply for a prepaid tuition plan to fund their kids' college education at major educational institutions. States offer prepaid tuition plans for individuals needing financial aid for college-based education. Some notable examples include the Maryland Prepaid College Trust in Maryland, the Florida Prepaid College Plan in Florida, the Michigan Education Trust in Michigan, etc.
Some organizations also provide prepaid tuition for students opting for college degrees on specific grounds. The eligible factors include students already enrolled in an accredited training program, employed part-time, or those having a particular GPA level.
Tips for selecting the correct investment plan for your child
Not all children are the same, and neither are their circ*mstances. For example, a person born in a lower-income family is better suited for federal financial aid eligibility. These children can apply for scholarship funds as well.
On the other hand, parents can arrange an education savings account for their child. Or they can save money monthly into a private investment account to let it grow with time.
Thus, you should consider your situation first when you choose what to invest in, like education savings plan accounts, mutual funds, etc. Here are some tips for making your choice.
Understand your financial goals first.
It would help if you took the time to decide on your main financial goal first before researching the investment choices, the applicable tax deductions, etc. For example, you should consider:
- Are you saving for your child's post-graduate or undergraduate program?
- Is your child attending another state or applying for an in-state educational course?
- Which field of student will your child go into- liberal arts, medicine, or vocational courses?
- What are the top institutes and their average fees for tuition, books, rent, and added costs?
- What federal income tax and state tax regulations apply to the present education programs?
Based on such questions, you can understand your main investment-related requirements and choose a suitable state's qualified tuition program.
Assess your risk tolerance level.
The income range of people does influence the investment objectives of people. This is because a family with a lot of income will have the capacity to withstand potential financial risks better. Assessing your risk tolerance level before applying for any investment program for qualified expenses is useful.
Parents with a stable income source can apply for a student loan as a part of the college savings plan for their children. They can pay the monthly student loan repayments on time consistently and add their child as the consigner to the account. Here, people should prioritize good financial planning through the repayment phase.
Brian Clark, Founder of United Medical Education, says, "Create a budget to manage education expenses wisely during college and explore part-time job opportunities to supplement income. After graduation, opt for a loan repayment plan that suits your financial situation and income level, such as income-driven repayment options, to avoid overwhelming debt obligations. Responsible borrowing and financial planning can help mitigate the risk of excessive student loan debt.”
Take your child's age into account.
Consider their age when researching investment choices for your child's education savings. You can assess the time to reach your savings goal and plan accordingly.
For example, one child is three years old, and your second child is two years old. The expected time when they will start higher education is upon reaching 18 years. Then, individually, you will have 15 and 16 years to grow your investment. In this case, a long-term education savings account is best for saving an appropriate amount, with added tax benefits.
Inflation rates.
Inflation relates to the cost of goods and services. But it does impact people putting their money into any investment account. For example, savings accounts are typically low-risk. But if the inflation rates are high, the changing interest rates will erode the saved amount in the account due to lowering buying power. Thus, you will lose money as an investor since the savings will not grow at the same rate.
Choosing an investment instrument with a good hedge for higher returns would be best. For example, due to fluctuating inflation rates, equity funds are good choices for college savings goals.
Tax implications applicable.
Tax deductions can change as per differing regulations to pay income tax as per federal and state tax laws. Factors like income inequality are also noteworthy.
Reportedly, people with higher incomes noticed a share rise from 46% to 54% in the projected period of 1979-2016. Thus, that is something you should consider while choosing your investment option for saving up your children’s future education-based finances.
Investment options and specific rates of returns for them.
It will help to research the different investment types before finalizing one for your child’s education savings plan. During this assessment, prioritize checking the predicted rate of return.
For example, mutual funds, gold bonds, equity mutual funds, and equity ETFs are good choices for long-term investment. On the other hand, Federal Deposits, Debt Mutual Funds, and Recurring Deposits are good examples of short-term investment options.
It would be best to diversify your investment portfolio to grow your finances for your child's future education securely.
Current education costs.
It would help to consider the average cost of education in colleges and courses before planning the investment portfolio for your children's future. The average fee and tuition cost in public colleges is $10,423 and $39,723 in private colleges. Out-of-state students attending public colleges must pay around $22,953 per academic year, per 2022-2023 statistics. Take note of such costs before choosing how much to invest and where.
Expected investment amount.
You should note the average investment amount you need to grow to give a satisfactory education to your child. Based on that calculation, you can choose the type of investment option and subsequent payment plan that will suit you. For example, you can select a SIP investment option for month-by-month payments for investment.
Or, you can choose a program that allows lump-sum investment for college funds. Consult with a credible investment manager to decide which plan suits you.
What about student loans? Do they need to be more for financing future education?
In the context of when to start saving up for college expenses, the argument of student loans comes up. Governmental and private lenders like banks, credit unions, and online lenders offer student loan options.
These loans are supposed to help the students manage college expenses like tuition fees, etc., at low interest rates.
Statistically, the average interest rate of federal student loans was 4.99% for undergraduate students and 6.54% (Direct Unsubsidized Loans) or 7.54% (Direct PLUS Loans) for professional/graduate students between 2022 and 2023. So, federal and private students get programs that give them enough financial backing for college education programs, even with limited or no credit history.
In the long run, applying for a student loan can be financially restrictive. The risks include:
More to pay over time-
Students must pay off the loan amount for college expenses at intervals, sometimes stretching on for years. As per the Federal Reserve, the average monthly student loan repayment is around $200-299 for borrowers, which is relatively high. The amount can vary depending on the course type, accumulated fees, and university. So, in this context, students who take a loan for a higher-cost course lose money over time as they continue paying relatively high monthly loan payments.
The toll on mental health-
Not meeting student loan repayments on time can impact the mental health of people, which is worth noting. Borrowers need help completing timely payments, accumulating enough per month, and other related concerns.
In such a situation, "employing proper stress-management strategies and practicing self-care" is essential, says Roy Lau, Co-Founder of 28 Mortgage. “For example, engaging in regular exercise, maintaining a support network of friends and family, and seeking counseling services can help combat the risk.”
Lowered quality of life-
After college, people have more costs to worry about, like house mortgage payments, retirement savings, and compulsory costs like paying state taxes. It, alongside the high student loan repayments, can become a significant financial hassle and reduce the quality of life.
So, despite the benefits of student loans, you should also focus on researching other investment instruments for your college savings plan. The best course of action is to combine many investment options for college savings.
Bottom Line
Overall, education is one of the most fundamental rights for all people, and it is crucial to start saving up for it early. You can try different personal budgeting moves to stabilize your finances. Or you can apply for solutions like personal loans and student loans for your child's future education savings. But this comes with specific risks if you need to manage your finances better.
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The best-case scenario is to research the different investment options available for college savings. Then, based on your situation and your child's future aspirations, you can choose the correct college savings plan.
FAQs
Opening a 529 college savings plan or contributing to it has no set age limit. The plan beneficiary can use this plan for eligible education expenses if they are a student enrolled in a qualified institution at least half-time.
Rolling over the 529 plan into a Roth IRA account is possible. But this is only possible from 2024. As per the SECURE ACT 2.0, the 529 plan beneficiaries can transfer their funds into a Roth IRA account for approximately 15 years. The lifetime limit set for the transfer is $35,000 for account holders.
During the 15 years, no penalties or taxes will apply, especially for the non-qualified withdrawals. The account must stay active for over 15 years, and the rollover amount will face the annual contribution limits of Roth IRA account types.
A rough outline for college savings is known as the 1-3 rule. This mentions that the total education plan cost should come from the person's savings (past income), loans they take up (future income), and current earnings (present income). The cost breakdown should ideally be one-third for each.
The qualified distributions for 529 plans are tax-free for beneficiary and account owner equally. Non-qualified distributions fall under the taxable income bracket, so federal income tax applies to these withdrawals. There is a 10% penalty as well.
The account holder is exempt from the penalty fee in extreme circ*mstances, like disability or death of the beneficiary. Otherwise, the owner or beneficiary in charge of the contributions owes the taxes on distributions if they make a non-qualified money withdrawal from the account. This is because they have to report the distribution of federal income tax returns with a 1099-Q form.
There is no specific annual contribution limit for people with a plan. But people must pay a gift tax for more significant contributions. The average high contribution limit varies state by state for a 529 plan. So, it would help to consider how much to contribute to your 529 plan.
Reportedly, the maximum contribution limit in Colorado is $500,000, $350,000 in Delaware, and $529,000 in California.
