Investing In Your Child's Education

By Investopedia Staff AAA

Let's face it: with steadily rising expenses in our daily lives, raising children is becoming more and more expensive. Forget about the $300 PlayStations, the $5 G.I. Joes or even the $30 Barbies. The growing concern for many parents is their financial readiness for sending their little and not-so-little ones to a post-secondary institution. Tuition costs alone are ranging between $5,000 and $30,000 per year, and the average degree requires four years to complete - provided, of course, that the kids don't decide to change majors or take their sweet time graduating. By the time we factor in the costs for books, spending allowances, housing and food, the total bill may be in excess of $50,000.

This is a significant amount of money for most people, and many of us are simply not ready for such a financially draining situation. Some parents aren't even aware of its severity until it's too late - when their children have only a few years left until high school graduation! Others may hope that their kids inherited the "smart" gene from old Uncle Bill and will earn plenty of scholarships to pay the costs.

For those of us who don't have that much faith in genetics, don't even have an "Uncle Bill", or aren't financially independent enough to cover the associated costs of sending kids to post-secondary institutions, there's another way. The U.S. government, realizing that these costs have been increasing steadily over the past few decades, has provided ways to make saving for educational fees easier. Presently, there are three popular methods whereby you can increase savings benefits and earn enough money to pay for your children's costs.

Coverdell Educational Savings Account
Formerly known as an Education IRA, the Coverdell account benefits parents and children as it provides a tax shelter for capital gains. In 2001, Congress passed a bill that allowed parents to increase annual contributions, depending on their income, to up to $2,000 per child. Thus, families with only one individual filing an income tax return less than $95,000/year are allowed to contribute $2,000/year per child. If the amount you file is between $95,500 and $110,000, the contribution limit is $1,800/year per child, and, if the amount you file is above $110,000/year, you're out of luck: the contribution amount is $0. If the family income has joint filers, the income limits are doubled with the contribution limits remaining identical.

Withdrawals from this account are penalty-free if they are made for qualified educational expenses, and are taxed as income at the beneficiaries' tax rate. Additionally, this account provides flexibility in investment content, and, should the beneficiary not require all the funds within the account, the remaining portions can be changed to the name of any other family member below 30 years of age. The one drawback of this type of account is that, if the beneficiary applies for financial aid, the assets within the account are designated as those of the beneficiary.

UGMA/UTMA Account
Using a child's social insurance number, an adult can open an account on behalf of a minor and act as the custodian of the account. Contributions by any single individual to a minor can be up to $11,000/year. If the minor is below the age of 14, the first $700/year is tax-free, the second $700/year is taxed at the child's rate, and anything above $1,400 is taxed at the parent's rate. If the minor is above 14 years of age, any investment income over $700/year remains taxed at the child's rate.

These UGMA/UTMA types of accounts provide flexibility as the funds do not have to be used solely for educational purposes; however, these accounts do have substantial drawbacks. First, the custodian has limited power in controlling what the assets are used for once the power of the assets is transferred to the beneficiary. What this means is that after the beneficiary legally becomes an adult, the funds are transferred into the beneficiary's name and he or she can use the funds for whatever he or she wishes, regardless of the contributor's approval. Second, there is no tax shelter as capital gains are taxed regularly, albeit at the beneficiary's rate, which is typically lower than that of the contributor. Third, as with the Coverdell account, these assets also count against the beneficiary who, possessing ownership, decides to apply for financial assistance for higher education.

Education 529 Plan
This is a service provided by all 50 states within the United States. These accounts create an educational tax haven for beneficiaries. Any gains within the account accumulate tax-exempt, and distributions for education-related expenses are also untaxed. Anybody can open one of these plans, contribute to it, and be listed as a beneficiary. Unlike the donors of the UGMA/UTMA accounts, the donor of the 529 plan is always in control of the money and can generally change beneficiaries without much difficulty; furthermore, the assets within the plan are not considered to be those of the beneficiary, so the funds will not significantly harm any applications for financial aid.

One of the serious drawbacks to this type of plan is the limitation placed on its investments. Many of the funds limit investments to only a few choices, which can be restrictive as a hands-on approach to investment management. Another concern is the longevity of these plans. The name of these plans refers to the tax loophole within the IRS code's section 529, whose existence is only guaranteed until 2010 by Congress. This can create some uncertainty for parents with children who won't be attending university until well after 2010.

The Bottom Line
The multitude of different savings plans for a child's education provides a situation that is important to take advantage of. Time is always an asset when trying to save, and tax-sheltered accounts help make sure that any earnings won't be slowly eaten away by the government. If time is no longer on your side, a 529 account is generally better as it will provide for the maximum tax savings in the shortest duration of time, without affecting your children's application for financial aid. However, if you don't want to be limited in your investment decisions and portfolio mix, the 529 plan may not be the best choice. If you have plenty of time before your child graduates from high school, the ESA may be a good choice. If you don't want to give full control to your children, the UGMA/UTMA accounts may not be the best route. Whatever you decide, make sure you understand the rules of the game before you play.

To find out how to help your kids budget, see What Are You Teaching Your Kids About Money?

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