One of my missions in life is to pay for our kid’s college education. My parents helped me with my education and that paved the way for our financially stable life. I know college isn’t right for everyone, but let’s save first and if he doesn’t attend college, we can always gift the account to other kids in the family or even earmark it for future generations. It’s better to sacrifice now and save up front than for our kid to be saddled with a big debt load.
College cost skyrocketing
Do you know how much college will cost in 15 years? According to the College Cost Calculator from savingforcollege.com, it will cost $313,615 to attend our alma mater (UCSB) for 4 years as a California resident. Okay, California is a pretty expensive state, so let’s try University of Oregon instead. That way we don’t have to move to California to get the in-state tuition.
Currently it cost about $25,000 per year to attend UO as an Oregon resident. I put that number into the calculator and the result turned out to be $221,771. That’s a lot better, but it’s still ridiculously expensive. Let’s just shoot for a nice round quarter of a million dollars. If it costs more than that, then he’ll have to get some loans and be more creative about financing his education.
We opened a 529 college account the same year RB40 Jr. was born. Oregon has a high state income tax (10%) and the 529 offers a tax deduction up to $4,530 for married filing jointly (2014.) That’s not bad and I’ll take any tax deduction I can get. The other big tax advantage of the 529 is that you won’t have to pay any tax on the earnings if you use the money for higher education.
My plan is to front load the 529 to maximize the tax advantage the 529 offers. Saving more upfront will enable the account to compound and grow over 18 years. Here is an example.
- If you save $70,000 when your kid is born, you’ll accumulate $294,040 (assuming 8% annual gain.) That’s $224,000 in earnings that you don’t have to pay tax on!
- If you spread it out over 18 years and save $324/month until your kid is 18, then you’ll have $156,585. It’s still a nice amount, but probably won’t be enough to pay for 4 years of college.
Of course, we don’t have a briefcase with $70,000 lying around. However, we can save about $10,000 per year while our kid is still young. Once we contribute $50,000, then we’ll evaluate the whole picture again. So far we contributed about $28,000 and gained over $9,000. That’s about 15% to a quarter million bucks.
There is one problem with the 529 plan. The 529 has limited investment choices. For now, we invest in US and International index funds, 50/50. It would be nice to invest in low cost index funds and individual stocks.
Coverdell Education Saving Account
I found out about the Coverdell ESA late last year and I’ve been meaning to look into it. From my research, it’s pretty much an educational Roth IRA. The earning is tax free if you use it for educational expenses. Now that it’s more than half way through 2014, it’s time to get the ball rolling with this. Let’s look at the pros and cons of a Coverdell ESA.
- Investment choice – You can invest in anything you want in the Coverdell ESA.
- Tax – Earning grow tax deferred. The fund won’t be taxed if used for qualified educational expenses.
- K-12 expenses – You can use the Coverdell ESA to cover qualified elementary and secondary education expenses.
- Transferable – The account can be transferred to another family member if needed.
- Favorable Financial Aid calculation – If a parent owns the ESA, then up to 5.6% of the value is included in the financial aid eligibility calculation. If the student owns the ESA, then it won’t be counted in the calculation.
- The contribution is not tax deductible.
- $2,000/year limit per child. That’s not much.
- There is an income limit. For joint filers, if your MAGI is more than $190,000/year, then the benefit will phase out. One work around is to give the money to the child and he/she can open their own Coverdell ESA.
- There is a time limit. You can only contribute until the beneficiary is 18. The fund must be used by the time he/she is 30. If the fund is not used, then the earning will be taxed as ordinary income plus 10% penalty.
Well, it looks like the Coverdell ESA is pretty similar to the 529. The main difference is the investment choices and the ability to use it for K-12 education expense. It’s a good option for us because we plan to contribute more than the state tax deductible amount, $4,530. We can put $2,000 in the Coverdell ESA and $8,000 in the 529. I like the flexibility of the ESA because I can invest in low cost index funds and individual stocks.
Where to open
I called Vanguard and found out that they removed ESAs from their product offering. If you have an ESA account with them already, they will continue to support it, but no new accounts. That’s too bad because most of my retirement accounts are at Vanguard now and it would have been convenient.
I called my other broker, Firstrade, and they offer the Coverdell ESA there. I just got the paperwork and will fill it out soon. They also don’t have any maintenance fees for active accounts so that’s great.
Overall, I think the Coverdell ESA is a good complement to the 529 if you plan to contribute more than you can deduct from the state income tax. It’s flexible and the earning will grow tax free. If you contribute less, then it’s probably easier to just go with 529.
Are you saving for higher education? Do you think it is worth it to sacrifice up front so the kids don’t have to carry a lot of debt when they start out?