Building a College Fund for a Newborn
Point of Interest
College funds are used by parents to save money for their child’s education without the use of a standard savings account.
Creating a college fund for a baby is a great way to get a jumpstart on saving for their future educational needs. As college costs continue to rise, planning as early as possible to deal with those expenses can help set your child up for future success. Thankfully, state and federal governments have created several different college savings plans parents can use to start saving.
What is a college savings plan, and how does it work?
College savings plans are investment mediums parents can use to save for their child’s future college expenses. The four most popular account types you can use to start a college fund for a baby are 529 prepaid tuition plans, 529 education savings plans, Coverdell education accounts (formerly education IRAs), and UGMAs/UTMAs.
Depending on the plan type you choose, you may be able to take advantage of significant tax savings either now or when you withdraw the money for your child. Look at the restrictions to each plan as some only allow you to pay for tuition costs, while others let you pay for additional expenses like room and board. Limits do exist on how much you can invest, such as annual maximums of $2,000 for Coverdell accounts.
Types of college funds for newborns
When it comes to saving for your child’s future college costs, there are many options. Weighing the pros and cons of each plan can help you decide the best option for your family.
529 prepaid tuition
A popular way to pay for your child’s future tuition costs is through a 529 prepaid tuition plan. These state-sponsored plans give parents the ability to pay for tuition at today’s rates by purchasing credits or units. The benefits are protection against rising costs, and depending on your state’s particular plan, you may be able to take advantage of some tax benefits.
Typically, 529 prepaid tuition plans do not allow you to prepay for things like room and board. Most plans also have specific state residency requirements and can only be used at participating colleges. These plans are not guaranteed by the federal government but may be guaranteed by your state government.
529 education savings
The second variation of 529 savings plans is the 529 education savings plan. Your state will offer either one or both of the two variations of the 529 plan. This version allows parents to invest in a tax-advantaged investment account to save for tuition, mandatory fees and room and board.
These state-sponsored plans can include a mix of mutual funds, exchange-traded funds (ETFs) and a principal-protected bank product. Most 529 education savings plans do not require a minimum investment to get started and are available through traditional investment advisors.
Coverdell education accounts
Formerly known as an education IRA, Coverdell education savings accounts are government-created, tax-deferred savings accounts designed to help families save for future educational expenses. While similar to 529 plans, there are some unique differences.
First, the maximum you can contribute annually to a Coverdell account is $2,000. Second, there are income limits and restrictions for the use of a Coverdell education savings account. In 2020, these limits are $110,000 for single filers and $220,000 for joint filers.
One of the biggest pros of using a Coverdell account is that withdrawals are tax-free as long as they do not exceed the cost of qualified education expenses. The drawbacks to the account are the limitations on who can create one, and the limitations on the amount of money you are allowed to contribute.
Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) accounts are custodial investment accounts parents can set up to save for their child’s future college costs. Actual investments in these accounts can include stocks, bonds, and mutual funds, but higher risk investments like margins and options are usually not allowed.
The biggest perk of these two plans is the tax benefit. The accounts technically belong to the minor, which means a significant portion will be untaxed or taxed at the child’s income level. Additionally, these accounts can be used to pay for anything for the child. So, even if your child decides not to attend college, they can still take advantage of the funds you’ve set aside for them.
Benefits of starting a college fund for a baby
1. Tax and financial aid benefits
As these plans are specifically designed for college savings, tax and financial benefits are built in to help. For example, UTMA and UGMA accounts allow you to cash in on tax savings by putting the asset in your baby’s name. A certain portion of income is tax-exempt for minors, and the remaining funds get taxed at the baby’s tax rate, which is usually much lower than the parents.
Additionally, earnings accumulating in qualified tax plans (529s) can accumulate tax-free and generally do not have to be included as income. Distributions from these accounts used for qualified higher education expenses are also not taxable.
Make sure if you do move forward with any of these plans that you take full advantage of all the benefits possible.
2. Reduces potential student loan debt
According to a 2018 report from the Federal Reserve Bank of New York, upwards of 44.7 million Americans have student debt. By starting to save for your baby’s future education expenses now, you can offset or completely remove this burden from their plate. Instead of starting their adult life in a financial hole, they can tackle the world with a leg up on their overall financial picture.
How to choose the best college fund for your newborn
To find the best college fund for your baby, you need to weigh the various options against your current financial picture. If you have enough cash and expect the costs of college to continue rising, you might be better off with a 529 prepaid tuition plan. If you qualify for the Coverdell account, you might want to see if that’s a good fit for your financial goals.
Do know you’re able to have multiple account types, so you may be able to get the best results by making multiple investments. If you’re unsure, you can always reach out to a financial professional to get some help. While most of these plans are through the government, you can sign up for them through traditional investment advisors.