The best way to pay for college out of pocket is with a 529 college savings plan. These plans were created in 1996 with the intent of participants setting aside funds to pay for college sometime in the future. The best part of these plans, and what makes them such an effective tool to pay for your kid’s college, is earnings in the plan grow tax-free if used for qualified higher education expenses. Why is tax-free growth so important and what are qualified higher education expenses?
Tax-free growth is so important because it saves you a ton of money. If you set aside money in a taxable account you will have to pay capital gains tax on any earnings when you sell an investment (for example if you bought a mutual fund for $5,000 and you sold it for $7,500 you will have a $2,500 capital gain that is subject to capital gains tax). Currently (and they can and have changed), capital gains rates will be either your ordinary income tax rate, 20%, 15%, or 0%. So the tax on your $2,500 capital gain can be anywhere from $990(.396 tax bracket * $2,500) to $0.
If you put that same investment into a 529 college savings plan your $2,500 of earnings will not be subject to capital gains tax as long as you use the earnings to pay for qualified higher education expenses. In the most egregious example you would not pay $990 to the IRS; instead with a 529 college savings plan that $990 goes to your kid’s college expenses. In other words, the full $2,500 instead of $1,510 goes towards paying the tuition bill. In addition, unlike with a taxable account, you will not owe taxes if you move money around in the account (like exchange shares of one low-cost mutual fund for another).
Fortunately, the government allows a wide range of expenses to be classified as qualified higher education expenses, such as, tuition & fees, room & board, books & supplies, and possibly computer related equipment & software and internet access if used for educational purposes.
What is also great about these plans is anyone can contribute to them. You can set up a plan and have grandpa and grandma contribute some birthday money to it. For example, the plan we have for our children makes is very easy for us to send out an email link asking for a contribution as little as $15 to our kids’ plans for birthdays and holidays. $20 towards a college savings plan goes a lot further than some plastic toy our kids are done with after two weeks.
How do I get access to 529 plans? There are two ways: direct sold plans and advisor sold plans. With direct sold plans you take it upon yourself to open up the 529 plan; with advisor sold plans an advisor acts as a middle man and sells you a more expensive plan. But beware, a more expensive plan can come with higher fee mutual funds (bad) and with the advisor skimming a few bucks off of the top (worse) for not really doing anything additional that warrants the added fee. High fee funds and a commission charge negatively impact the returns of your plan. Over time you will have less money for college expenses in an advisor sold plan than with a direct sold plan. Clearly, the choice is obvious, go with a direct sold plan.
If you need help check out this site to learn more about 529 college savings plans, or contact a fee-only financial advisor who specializes in college planning if you want to pay for his/her guidance. Keep in mind, a fee-only advisor should only charge you a one-time nominal fee to set you up with a direct sold plan (not advisor sold plan).
The nuts and bolts of college savings plans: plans come with contribution limits, so check with the plan administrator; you may owe gift taxes if you contribute more than annual gifting limits; you will owe taxes and possibly a 10% penalty if you withdraw money from the account and do not use it for qualified higher education expenses; some states will offer a tax deduction on your state tax returns if you contribute to your state’s plan; if your kid’s situation changes and she doesn’t end up getting a higher education, you still have many options to name a new beneficiary of the account (say a niece or nephew), so all is not lost.
The bottom line: if you think you’ll be footing the bill for your children’s higher education needs start saving with a 529 college savings plan today – it’s the smartest move you can make. One of the best gifts you can give your children is the gift of an education. It’s clear how important an education is in today’s society, but education, especially higher education, comes with a hefty price tag. There are various ways to pay for college, such as scholarships, grants, loans, or to pay outright for the education itself. Scholarships, grants, and loans aren’t guaranteed to be available, so some parents will have to fall back to paying for college out of pocket.