Meet Mark and Sophie. They’re exhausted. They’ve recently had a baby girl named Maddie, and between the midnight feedings and the baby proofing, they’ve barely had to time to sleep, let alone time to talk about a very far-off topic: funding her college education. Unfortunately, that’s also a mistake. College, while undeniably valuable, is mind-numbingly expensive.
One year of state college clocks in at around $28,000, and that number will double or triple over the next 17 years. Scary right? Mark and Sophie are clearly overwhelmed. However, they actually don’t have to be, for two reasons. One: They don’t have to save for 100% of the cost ahead of time. In fact, most financial experts think a third is totally adequate. Two: They don’t have to use conventional savings accounts. There actually exist two investment accounts, 529 plans and Coverdell ESAs, that make it incredibly easy to grow your tuition money tax-free.
Even better, these accounts don’t even seriously affect financial aid. At most, they’ll only lower it by 5% of their total value. Sounds pretty great right? So how do 529 plans and Coverdell ESAs work exactly? Well, both allow you to deposit after-tax money into an investment account, and then withdraw it tax-free to pay for the educational expenses of a named beneficiary, like a child or grandchild. This is true even if the expenses take place outside of your state, though be warned, all withdrawals not used for education are subject to 10% penalty, plus tax.
So that’s how 529 plans and ESAs are similar. Here is how they’re different. One: The contribution limit for an ESA is $2,000 a year, whereas for a 529 plan it’s $300,000 over the lifetime of the plan. Two: ESAs have contribution restrictions for high earners, 529 plans do not. Three: ESAs don’t qualify for state deductions, whereas 529 plans can, depending on the state. Four: ESAs make it much harder to change beneficiaries, plus they force you to distribute the funds once the beneficiary turns 30. In addition, under certain ESAs, beneficiaries can actually gain control of the funds once they turn 18. In contrast, 529 plans have none of these traits, plus you can generally change the beneficiary at any time.
Five: And here’s the major advantage of an ESA. They’re easy to open at almost any brokerage and can be used for both primary and secondary education expenses. In contrast, 529 plans are restricted to college expenses and are only available through your state, though admittedly several great state plans are available nationwide. So which account should you choose? Well, despite their greater range of acceptable expenses, Coverdell ESAs are not our preferred option for college savings.
They simply have too many flaws, ranging from low annual contributions to worse tax treatment. That’s why instead we recommend opening a 529 plan, while following these seven rules.
One: Choose a savings 529, not a prepaid 529, as they’re way less restrictive.
Two: Pick a 529 with an age-based option, as these require no work, and automatically adjust their holdings based on your child’s age.
Three: To save money, avoid 529 brokers, and instead, open your plan directly through the state’s website.
Four: Once you’ve picked your plan, use our recommend calculator to understand how much you should save, ideally through automatic deposits, each month. Also, be sure to keep these contributions below $14,000 each year to the avoid federal gift tax.
Five: Encourage helpful relatives, like grandparents, to contribute to your 529 plan, rather than setting up their own. This will help you avoid the financial aid nightmare that comes with grandparent owned accounts.
Six: Register for our favorite free education rewards site, as it makes it easy to earn 529 money on everyday spending. Seven and Finally: Understand that while saving for college is important, retirement comes first. Don’t start putting money into a 529 plan until you’ve put to 10-15% of your own paycheck into a retirement account. Hopefully you, Mark, and Sophie now better understand how to save for your child’s education. Be sure to watch our next video, which details finance and divorce, and be sure to check out our website, where you can find more educational material and great 529 plans.