Should I Have an Education Savings Account?

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Dear Chuck,

I have 2 daughters that are only 2 years apart that are still in elementary school, but I'm concerned about the cost of college. When is the best time to start saving, and can you explain education savings accounts? I am thinking this is the way I want to help them get their degree without debt.

Thanks,

Mom of Future College Grads

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Chuck Bentley

Dear Mom of Future College Grads,

You are wise to be thinking ahead!

Solomon, the wisest man who ever lived, tells us that "Wealth gained hastily will dwindle, but whoever gathers little by little will increase it." (Proverbs 13:11 ESV)

Saving a little every month will accumulate over the years and help your children avoid the burden of student loans.

There are numerous ways to save for college.The two most popular are the 529 college savings plan and the Coverdell Education Savings Account. Both are similar to a Health Savings Account (HSA) or retirement account. They are similar in that the money goes to investments like mutual funds, and withdrawals must be for qualified expenses like tuition, room, board, books, calculators, computers, printers and other approved items. It is also helpful to know some specifics about each one to help you make your best choice.

529 Plans

These offer benefits for parents and students, functioning like a Roth IRA. Accounts grow tax-free and distributions for qualified expenses are not taxed. They are owned by the contributor, assessed at the 5.64% parental asset rate for the expected family contribution (EFC), and distributions are not counted as base year income on the FAFSA. This means they do not hurt you when applying for financial aid.

These tax-deferred investments offer the most flexibility and tax-advantages. Withdrawals must meet qualifications or a 10% penalty is charged. In addition, state and federal taxes on the earnings for your tax bracket will be applied.

Contributors can invest aggressively and catch up for any years missed because there are no contribution limits or income restrictions. They will move state to state, and from one child to another. In addition, the beneficiary can be a child or grandchild and can be established by friends or family.

Control of the account stays with the contributor. There's no limit to the quantity of plans you can establish, but avoid exceeding the cost of education or the limit set by the state. All contributors need to keep each other informed of their plans. These can fund a broad range of post-graduate programs including qualified certificate programs and continuing education.

In a prepaid tuition plan, contributions are pooled with other investors to prepay the cost of a designated college at today's prices for future use. There's a limit on yearly contributions and they function like IRAs.

State-sponsored 529s allow investors to contribute after-tax money that grows tax-free for later withdrawal without federal taxes or penalties if used for qualified expenses. Beneficiaries are free to choose the college of their choice.

Any excess money in the account after college completion will be penalized and taxed by both state and federal governments. So underestimate what you need to save, and work to receive grants and scholarships! Advisors suggest aiming for total in-state public college costs. The limit for contributions is higher than the Coverdell and there's no age limit for the beneficiary.

See SavingforCollege.com for more information.

Coverdell Education Savings Accounts (ESAs)

After-tax dollars (not tax-deductible) can be distributed to private K-12 funding, college or grad school. Contributors must earn less than $220,000 a year per couple and are limited to yearly contributions of $2,000.

Once a student turns eighteen, contributions must end. The custodian controls the account, and the beneficiary may take over at the age of majority, which is usually 18. There's no federal tax charge when money is used for qualified expenses. Earnings grow tax-free. The account must be closed before the beneficiary turns 30, but the money can be moved to a 529 for the same beneficiary or relative, or a regular brokerage account. Note, taxes and penalties may be owed.

Simply Save

Roth IRAs are another option. These are designed to be retirement-savings vehicles, so if not used for college, the account owner can use the money for retirement. There are contribution limits and no penalty for withdrawals prior to age 59½ if the money is used for qualified higher-education costs. However, earnings may be taxed for early withdrawal. And, the entire withdrawal (principal and earnings) may be considered income and affect financial-aid applications.

The simple option, with fewer benefits but more flexibility, is to save in your own account and invest as desired, paying for expenses when they are due. With this approach, you can access your own money if you need it for retirement or an emergency. You miss out on potential tax benefits but penalties are avoided.

Chuck Bentley is CEO of Crown Financial Ministries, the largest Christian financial ministry in the world, founded by the late Larry Burkett. He is the host of a daily radio broadcast, My MoneyLife, featured on more than 1,000 Christian Music and Talk stations in the U.S., and author of his most recent book, Money Problems, Marriage Solutions. Be sure to follow Crown on Facebook.