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The following is a guest post from Robert at The College Investor. You can check out his bio below. To learn more about guest posting on iHeartBudgets, please contact me. Thanks for the help, Robert, while I’m swimming in numbers!
There are two schools of though when it comes to saving for your child’s future college expenses. While both are valid in several different ways, I want to highlight why leveraging an education savings account can be very value-added in certain circumstances as well.
The first school of thought when it comes to saving for college is that parents should focus on themselves first. This makes sense because you can’t get a loan for retirement, but there are tons of financing options for college. In this scenario, parents just stash away their own money, and when the times comes for their children to go to college, they pay for what they can out of pocket, and then help their student find financing for the rest via student loans.
The second school of thought when it comes to education expenses is that parents should start a college fund, or education savings account, for their child as they’re growing up. There are several main types of education savings accounts, but the main benefit is they act like IRAs for your children. Most of them allow the money in the account to grow tax free, and as long as the distributions are used to pay for qualifying educational expenses, the distributions are also tax-free.
How Financial Aid is Calculated
The whole reason that the way you save matters is because it can seriously impact the way the financial aid is calculated. This is especially important if you’re in school 1, where the parents will save and pay themselves.
Right now, for Federal Financial Aid, parental assets are assessed at a 5.64% rate in determining the student’s Expected Family Contribution (EFC). This means that if the parents have $100,000 in assets, it is expected that they can contribute $5,640 to educational expenses each year.
However, the metrics are different when it comes to the student’s assets. For the student’s assets, the rate jumps up to 20%. So, if the student has $20,000 in assets, they will be expected to contribute $4,000 per year. However, this doesn’t include education savings accounts. These are still assessed at the parental rate of 5.64%, even if the student owns them. That’s a nice break.
Why Education Savings Accounts Make a Difference
Let me share my story about why I think education savings accounts are important and can make a small difference for students who may need financial aid. That 15% difference can be a big savings if it allows you to get a good rate on your student loans.
Growing up, my parents fell into the first school of thought – never savings for me, but told me that I would get a set amount towards tuition when it came to paying for college. Beyond tuition, everything else was on me.
However, my grandparents were more generous. When I was a baby, and all through my childhood, they essentially invested on my behalf in a UGMA account. This is the Uniform Gifts to Minors Act, which says that I would be the owner of the account, but that someone else (in my case, my parents) was the guardian of the account until I turned 18.
The problem with this setup is that all the assets are in my name. These weren’t education savings accounts, just standard brokerage accounts. As such, not only were all transactions taxable throughout my childhood (granted my parents paid the tax bills), but when the time came to apply for financial aid using the FAFSA, all of the assets reported were my own and calculated at a 20% EFC.
This essentially crushed any hopes I had of getting even the smallest financial aid or even subsidized Stafford Loans. While my parents contributed towards my tuition, I had no other choice but to work to pay for my room and board and books. While I think it was a positive developmental experience for me, I also think it’s important for future generations to try to avoid this by simply investing in the correct type of account for college.
Use the Correct Type of Education Savings Account
So parents, while your children may be young, chances are that others may want to give them gifts or you may want to save for their education. Make sure that you do it right by setting up the right types of accounts in advance so that you can protect your children financially later on. This could help your children avoid student loan debt and start their future on the right financial footing.
Are you planning to save for your child’s education, or are you going to pay out of pocket? Are you using an education savings account currently?
This article was written by Robert Farrington, who blogs at The College Investor, a personal finance site dedicated to helping people get out of student loan debt and start investing.
15 thoughts on “Why You Must Use an Education Savings Account”
We have a 529 set up for our little guy. This last year we put enough in there to max out our state tax credit (20% baby!) and my dad did the same for us. This year we probably won’t get it maxed out since we now have to pay for the baby, but we will still put a good amount in there. I think my dad is probably going to put his money into an account for my sister’s new baby and then either alternate years or do half the amount to each. Either way it is BEYOND generous of him to do that and we are very blessed that he is!
That’s a pretty sweet deal. My state doesn’t have an income tax, so I’m still weighing the ESA vs. 529.
Gifts are great and you should be very appreciative of them always! Just hint them in the right direction to set you up for success. It is terrible when a gift can become burdensome.
You must live in Indiana, too! We also get that 20 percent tax credit and maxed it out this year, so $1000 off our taxes. Love it.
We have UGMA’s set up for all of our kids and plan on moving to a 529 here in the near future. We have several family members that want to put money away for our kids and that will allow us to have a better vehicle to put it in. We want to save what we can for them, but we also want to balance that with retirement savings.
Yup! A college education won’t necessarily feed you in retirement. You know, unless they’re an astronaut or something 🙂
I think that’s a great call to move to a 529. You can see from my experience above that a UGMA has some disadvantages.
529 Plans are the best way to save for college. I am lucky in that I live in a state where I can invest in any state’s 529 plan and still get the state income tax deduction.
My state has no income tax, so I’m wondering if the ESA would offer more investment options?
That’s a great perk! Some states really limit you on what you can do, which doesn’t make any sense!
Jake, thanks for hosting my article today! I hope you stay sane during tax time!
We have saved monthly for our kid’s college expenses since they were babies. We also put all of their gift money in their accounts on a regular basis.
The state that I live in gives a 20% tax credit on the first $5000 that we contribute in any year so that makes it an even better deal.
Great post. After reading this it makes total sense to have an educations savings account. One question I have is what if your son/daughter decide not to go to college what happens with your money?
If your child decides not to go to college, the education savings account turns into an IRA, where you can withdraw, but pay ordinary income tax plus a penalty. However, the savings you get from not paying over time usually outweighs this.
That’s a very good reason to start an education savings account. Here’s another fact about financial aid that wasn’t mentioned. If the parents are divorced, the student only has to list ONE parent’s finances. Obviously you would want to list the parent with the least assets and income if this situation applies to you.