The Quick Guide to Education Accounts: 3.2 Tax-Free Ways to Invest for College

Should you save for your children’s education?

A better question is “should you invest for your children’s education?”

There is a simple cut and dry answer here…it depends…it’s really up to you.

Did I say cut and dry? Forgive me.

You are not obligated to pay for their college. It’s not your responsibility as a parent.

However, it is nice to be able to help them out. Here are the best ways to do it…

The Age Old Question

As long as I can remember, people have been talking about whether or not you should pay for your kid’s college.

Do I? Yes. My wife and I save for each one of our four children. Not enough for a free ride, but enough to make them feel like college is a legitimate option, even without scholarships.

I realize that you don’t have to go to college to be successful and sometimes it makes sense not to go, so nobody is forced in our home.

The thing is, it doesn’t take that much money, invested monthly, over many years, to build a decent education fund.

Let’s look at ways to build that education nest egg…

1. The Popular: 529 Plan

529s are offered accross the entire United States, but they are state-specific.

That doesn’t mean you have to open one in your state though.

You can live in one state, open an account in another and go to school in a completely different state.

If the money is used for education, your earnings are tax-free. There is a 10% penalty, if it’s not used for education.

2. The Less Common: Coverdell’s ESA

A Coverdell ESA (Education Savings Account) is another option.

This option may be useless for your child’s college fund (due to the restrictions), but they do work for some people and certain situations.

The contribution limit is currently $2,000/year (per child), which is quite low. But if you don’t plan on investing more than that, it doesn’t really matter.

There is one unique (non-college) benefit of using Coverdell’s though…you can use the money to pay for other schooling, such as elementary or private schools.

Here are the positives to a Coverdell’s ESA:

• You can use the money to pay for lower level education
• You can use the money to pay for a tutor of test prep classes
• You can easily transfer the money to a different child

Here are the negatives to a Coverdell’s ESA:

• The contribution is quite low for an education fund ($2,000 currently)
• The funds must be used within 30 days of the beneficiary turning 30
• The beneficiary must be under 18 while you’re contributing to the fund

3. The Classic: Roth IRA

IRAs aren’t just for retirement.

Roth IRAs can actually serve two purposes. Retirement and education.

You can withdrawal money from your Roth IRA, before you are 59 1/2, without the 10% penalty, if the money is used for higher education.

There are two schools of thought on using Roth IRAs for education.

One side says it’s a bad idea, because most people aren’t fully funded for retirement. In other words: don’t bankrupt your retirement account for your children’s college. The contribution limit is $5,500 (as of 2014), so you don’t have a whole lot of room to invest for your retirement and your child’s education in the same account, but you should also keep in mind that the contribution limit is per individual, not per household.

The other side says it’s a good idea, because you have the option to use the money for retirement if your child doesn’t use it for college. That makes sense too.

It all comes down to where you’re at with retirement and what your priorities are.

Here are the positives to a Roth IRA:

• You can use the money for retirement if your child doesn’t use it
• You have a wide range of investment options (basically anything)

Here are the negatives to a Roth IRA:

• The contribution limit is $5,500, which limits your retirement funding

.2 More Options

These are what I consider the .2 options in “3.2”. The above options are generally preferable, but there are some circumstances where you might need these:

Municipal Bonds are an option, especially if you’re in a high income bracket. They usually won’t yield a very high return (around 3-4% on average), but you also aren’t forced to use the money for education.

Custodial Accounts. The Uniform Gifts to Minors Act and Uniform Transfers to Minors Act allow you to make your child the trustee; however, once the child turns 18 or 21 (depending on your state), they can use the money for whatever they please. That’s a scary thought. Think: The Parable of the Prodigal Son.

Final Words

All of these accounts can grow tax free. Figure out what works best for you.

If you want to save for your child’s education, you have options. Just get started.

But remember, it’s not your responsibility. It’s a privilege for your children, not a right.

Photo Credit: Mikko, Skye, Bradshaw, Ralph