We typically recommend making sure you are on track for retirement before funding your children’s education. This is because education can be funded by borrowing if needed, sometimes at relatively attractive interest rates and in a tax efficient manner. Financial aid may also be available. On the other hand, if you don’t achieve your retirement goals then borrowing is less likely to be an option, and you may unintentionally impose an additional financial burden on your children.
However, saving for educational goals with specific savings vehicles can make sense. Your income and capital gains taxes can be deferred or reduced, and it can offer a tax efficient way to transfer funds to your children or grandchildren. However, this tax efficiency does come with constraints regarding how the money is spent, who it is spent on and who controls it. If you set up a trust for your child it may also impact their eligibility for financial aid at college.
In the worst case, you may find you have to pay penalties if you don’t spend as much on education as you anticipated. This may happen if costs are lower than planned or the child doesn’t attend an eligible institution. In the case of a trust, you child once they reach 18 or 21 may be free to spend the money as they see fit, without your control.
If you are saving for educational goals and want to achieve greater tax efficiency there are several options. 529 plans are most commonly used for funding college though, like 401(k)s, good and bad plans are offered in terms of fees and investment options. Coverdell ESAs offer a newer alternative for broader educational spending include elementary and K-12. Trusts offer the greatest flexibility in term of spending but less flexibility in terms moving money between children, and less control once they become adult. Finally, a Roth IRA can also fund education expenses, which can be a good option if you aren’t sure of the extent of your educational savings needs and would have a Roth IRA anyway for retirement saving.
529 plans are most common and offer a tax efficient way to save, but the scope of what the money can be spent on is limited to tuition related costs (including things such as books) and room and board, if you save too much, then the remaining money may attract withdrawal penalties. A 529 plan is typically treated as an asset of the parent rather than the student, which can help with financial aid eligibility. 529 plans come with a specific menu of investment options dependent on the plan. This can be drawback if the funds in the plan are relatively expensive or lack diversity. It can pay to do research to find a well regarded 529 plan.
Coverdell ESAs (Education Savings Accounts) are less well understood then 529 plans because they are newer. However, it can be a useful alternative to a 529 plan in some situations. The options for spending ESA funds are generally broader including elementary and K-12 costs. In addition the investment options are also broader than most 529 plans. However, as of 2014 the contribution limit is $2,000 per year whereas 529 plans often permit much larger contributions running up to as much as $300,000 in total. So wealthier individuals may find a 529 offers greater savings potential.
Another strategy to consider is to set up a trust for your child. This is broader in scope than just educational saving. This basically means that you control the funds until they are 18 or 21 but after that the investment transfers to them. The primary benefit is that the money can be taxed at the child’s tax rate, which is likely to be lower than the parents in most cases. The main vehicles are UTMA (Uniform Transfers to Minors Act) and UMGA (Uniform Gifts to Minors Act). These trusts are typically considered assets of the student and therefore are likely to reduce financial aid eligibility. A trust ultimately transfers money to your child, so it cannot be reversed and trying to do so would likely attract significant tax and potentially even legal penalties. This will likely also be the case if you wish to move money between children. With a trust there is potentially much greater flexibility relative to a 529 or ESA concerning how the funds are spent beyond education.