A college education can play a crucial part in a loved one’s long-term happiness and financial security. Young adults with a bachelor’s degree earn 66% more than high school graduates while experiencing lower unemployment.2 Yet with income growth generally failing to keep pace with rising tuition, investors intent on passing along the benefits of higher education face a tremendous challenge.
For the 2015–16 academic year, the average total cost of attendance for students at a four-year private university was $47,400, including tuition, room and board. For the cost-conscious, public institutions present a lower cost alternative, averaging $23,300 for students who paid in-state tuition.2
Parents and their children can pay for college in a variety of ways. At four-year private colleges, grants and scholarships paid two-fifths of the cost, compared to covering less than one-quarter of the costs at public universities.3 However, parent income and savings are the primary source of funding, surpassing scholarships and grants for the first time since 2010.3
One savings option that has grown in popularity is the 529 college savings plan. Named after the IRS code section that created it in 1996, 529 plans are specifically designed as a tax-advantaged way to save for higher education expenses, such as tuition, room and board, as well as required books and supplies.
These plans allow earnings on investments to accumulate tax-free. What’s more, as long as the money is spent on qualified higher education expenses, withdrawals are also free from federal taxes.
Individual states generally are the sponsors of 529 plans, while plan assets are professionally managed by independent investment firms or state government agencies. A number of states allow a deduction from (or a credit against) state taxes for all or part of a contribution to certain 529 plans.
No matter how much you earn, you can open an account and contribute as often as you like. Generous contribution limits allow parents to invest until an account’s value reaches up to $500,000 in some states for each beneficiary. If the beneficiary doesn’t use the money, part or all can be assigned to a new beneficiary within the family without income tax consequences.
In addition to 529 plans, other college savings options include Coverdell Education Savings Accounts (ESA) as well as Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts. However, several factors may make them less than ideally suited to an investor whose goal is paying a sizable share of the college bill.
Coverdell ESAs offer tax-free growth, and withdrawals can be used to pay qualified expenses from elementary school through college. However, among the biggest drawbacks are income limits and relatively low contribution maximums compared with 529 plans.
Historically, many families have employed UGMA/UTMA accounts as college savings vehicles. However, compared with 529 plans, they come with some significant drawbacks. UGMA/UTMA accounts don’t offer tax-free growth, and their assets are generally not treated as favorably in financial aid calculations. For more information about your options, speak with your financial professional.
Grandparents, family and friends may also be willing to help defray expenses. Encourage them to make contributions to 529 plans on milestones such as birthdays and holidays.
In addition, students can help mitigate costs by using personal savings and working during the school year and the summer. As a final resort, families can borrow money to help pay for college. Student loans are available, and parents can borrow money as well.
While parents may not be able to help students save the full amount for college expenses, small dollar amounts invested consistently may grow to something substantial, and no amount is too little to make a difference.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses, summary prospectuses and CollegeAmerica Program Description, which can be obtained from a financial professional and should be read carefully before investing. CollegeAmerica is distributed by American Funds Distributors, Inc. and sold through unaffiliated intermediaries.
Depending on your state of residence, there may be an in-state plan that offers tax and other benefits not available through CollegeAmerica. Before investing in any state's 529 plan, investors should consult a tax advisor.
If withdrawals from 529 plans are used for purposes other than higher education, the earnings will be subject to a 10% federal tax penalty in addition to federal and, if applicable, state income tax.