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With the cost of college rising year over year, many parents plan to pay for some portion of their child's college education with cash they saved up and then finance the rest of it with student loans, grants or scholarships.
Yet most parents end up saving less than they plan to. According to the Education Data Initiative, on average, parents expect to pay roughly 30% of their child's college expenses but end up paying only 10%. If you want to avoid this common pitfall, it's essential to start investing early and to choose the right investment vehicle.
Select spoke to Mark Kantrowitz, higher education expert and author of How to Appeal for More College Financial Aid, about whether parents should opt for a 529 plan, brokerage account or Roth IRA when saving for college.
A 529 savings plan, which gets its name from the tax code, is the go-to option for investing for college because of the tax benefits it offers. These state-sponsored investment accounts give people the option of investing in different stock or bond funds, and you won't pay taxes on your investment gains or when you cash out to pay for qualified educational expenses such as tuition, room and board, supplies.
Some states even consider 529 contributions tax deductible and some give parents a head start in investing for college — New York, for example, gives all public school students $100 that's invested in a 529 savings account.
While 529 savings plans have a wide range of benefits, there are a few downsides. The cash you invest in a 529 must be used for education expenses. If it isn't, you'll have to pay a 10% penalty fee plus income taxes on your withdrawals.
There are exceptions to this. You won't have to pay the penalty fee if your child receives a scholarship or attends a U.S. military academy, says Kantrowitz. So if your child gets a scholarship, you can get access to the money you saved without having to pay any penalty fees.
Another investment vehicle to consider is a Roth IRA. According to Kantrowitz, a 529 savings plan and a Roth have a lot in common: You won't be taxed on your investment gains, and you can make qualified withdrawals tax-free.
A Roth IRA is typically used as a retirement account, and so there are limitations on how and when you can use the money. When you withdraw investment gains from your Roth IRA before you're 59 and a half, you have to pay a 10% penalty fee. If, however, you have a Roth IRA for more than five years and are using the withdrawal for qualified educational expenses — such as tuition, fees, books and supplies — you won't have to pay the penalty fee or any income tax.
And if your child doesn't go to college, you can still use the money for other things, like your own retirement, or even saving it so your child has a big head start on their own retirement savings.
Brokerage accounts also offer flexibility that 529 savings plans don't. While money you withdraw from a 529 plan or Roth IRA must be used for qualified expenses, you can really do anything you want with the cash you invest in a brokerage.
You might also be tempted to use a brokerage accounts because it gives you more investment options. You can invest your money in individual stocks, bonds as well as index funds. With 529 savings plans, individuals are usually only able to choose between a few different stock and bond funds.
There's a major drawback to investing your college savings in a brokerage account: long-term capital gains tax. You could pay up to 20% depending on your income tax bracket, says Kantrowitz. That $100,000 that you have invested for college in a brokerage account could end up being only $85,000 after you pay taxes on it.
Whatever investment vehicle you choose, it's important to understand the impact that your college savings could have on your FAFSA application and your expected family contribution (EFC).
Your EFC is a number used by colleges to determine how much financial aid you're eligible to receive.
You can think about it like this: Colleges decide on a cost of attendance (this typically includes tuition, room and board, and books and supplies) they then subtract the EFC from the cost of attendance to determine the amount of financial aid your child is eligible for. So if your family has a higher EFC, your child will be be eligible for less need-based aid from the state and federal government and the institution.
There are a number of factors that go into determining your EFC, but the most important factors are the student's income and the parent's income. A parent's assets and a student's assets, on the other hand, are not weighed as heavily. Accounts are also weighted differently depending on whether the child or the parent is considered the owner.
In other words, using certain types of investment accounts for saving for college can increase your EFC and decrease the amount of aid a child receives because some investment accounts are reported as assets while others are reported as income.
A 529 savings plan is considered a parent asset, so the amount that's saved in it only reduces aid eligibility by up to 5.64%. For example, if you have $100,000 invested in a 529 plan, your aid eligibility will be reduced by as much as $5,640.
While this may seem like a lot of money, consider that a distribution from your Roth IRA could reduce your eligibility for need-based aid by as much as half of the distribution amount since it's reported as income not an asset, says Kantrowitz.
So if you decide to raid your retirement savings and use $100,000 from your Roth IRA to fund your child's education, you could end up reducing your aid eligibility by up to $50,000 because money withdrawn from a Roth IRA is considered parent income. (The value of your IRAs or 401(k)s are not calculated in your EFC if you're not withdrawing money from them.)
For a taxable brokerage account, the reduction in aid eligibility depends on whose name the account is in. If the brokerage account is in the child's name, it's considered a student asset and will reduce aid eligibility by 20% of the account's net worth. If the brokerage account is in the parent's name, it will reduce aid eligibility by up to 5.64% of the account value because it's considered a parent asset, says Kantrowitz.
Overall, a 529 savings plan is the best option when investing for college, yet there are still a few exceptions.
"A family might not want to save in a 529 plan if there are serious doubts as to whether the child will go to college, if the parents want a broader set of investment options or if the family expects to need to spend the money on non-qualified expenses," says Kantrowitz.
If you're interested in getting a brokerage account and a 529 savings plan, check out the options offered by Wealthfront, which offers individual retirement accounts, robo-advisors and 529 savings plans.
If you're just looking for an IRA, consider a Schwab IRA, Fidelity Investments IRA or Vanguard IRA (see our full list of the best Roth IRAs). And if you'd prefer to go the 529 route, check out Select's round-up of the best 529 plans.