College is expensive, so it is little wonder that parents sacrifice so much to stash money away for their children’s college education. And with only 17 or 18 years to grow the money, investing is the best vehicle for this financial objective. But are mutual funds good for college savings?
Mutual funds are not good for college savings because tax implications often harm the benefactor. Other investment vehicles are more suited for this financial goal. However, mutual funds are good for adding to your portfolio.
This article will discuss why mutual funds are not the best investment toward college savings, as well as better ways to set aside tuition money. College might be expensive, but this article will give you some ideas on how to save for the costs of higher education.
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The Truth About Mutual Funds and College Savings
Mutual funds are enticing to those looking to save for college for many reasons.
Many parents start saving for their children’s college education when their children are born. However, no one knows if the child will go to college or not, so parents must invest carefully or face penalties for withdrawing the funds.
Another reason mutual funds are often used for college savings is that there is no limit to how much you can invest in mutual funds. However, earnings on mutual funds are subject to annual taxes.
In addition, you pay another tax, or a capital gains tax, when the shares are sold.
However, the biggest problem with mutual funds is that this investment vehicle can reduce your child’s financial aid eligibility by as much as 20% if the child owns the account. That number decreases to almost 6% if the funds are in the benefactor’s account, but the tax implications are more significant.
For these reasons, there are much better ways to save for college.
Better Ways To Save for College
Although financial aid is relatively easy for many students to receive, it rarely covers the entire cost of college. We must also remember that even if the financial aid package will cover all classes, room and board, meals, and books, the package includes all available money.
In other words, financial aid packages include grants and scholarships that do not have to be repaid, as well as loans that require repayment.
Although government-backed student loans are traditionally assigned a much lower interest rate than private student loans, or credit cards, the debt can follow the student for twenty or more years.
This debt then often causes them to delay many life decisions, such as purchasing homes.
Therefore, it is prudent to plan for your child or grandchild’s college education. However, please note that any plan you select will potentially decrease the student’s financial aid eligibility generally by 5% to 20% of the account’s balance.
Even so, it is still best to plan and save for college, and some of the following ways may be better options for you than mutual funds.
529 Savings Plans
These offer parents and guardians more security as they save for college, and it is frequently the plan financial advisors suggest to parents and guardians.
While contributions made to 529 plans are not deductible, the fund’s growth is tax-free, which means that, unlike mutual funds, you do not give up any earnings to federal taxes. Also, many states offer tax breaks on 529 Savings plans, which make them an even better option for college savings.
Another reason this option is better than mutual funds is that the benefactor remains in control of the account and can withdraw from the account at any time. Tax benefits will change if the reason is not related to education, though.
This account can also be transferred to another beneficiary, which is nice because, as I said in the beginning, no one knows when opening these accounts if their child will go to college or not.
Custodial Accounts
These can be done by an adult with the approval of the custodial parent.
Because of the Uniform Gift to Minors Act (UGMA) and its extension act, the Uniform Transfer to Minors Act (UGTA), minors can receive money from this account at special tax rates.
There are a few drawbacks to saving for college in this way. The biggest drawback is that the fund cannot be transferred or changed to another child if the original beneficiary opts not to go to college.
Another issue is that the beneficiary cannot receive money from the account until adulthood in the residing state.
This requirement means that in states where the Age of the Majority is twenty-one, the account could not be used until the student’s senior year. Thus, like the mutual fund, custodial accounts can reduce the student’s financial aid eligibility by 20% of the account.
However, the main drawback of this account may be that once the beneficiary reaches adulthood, the money can be spent in any way as no laws require that the money be spent on education.
Given that many lucrative careers do not require a college education, the custodial account may be an option that simply invests in the child’s future without mandating a specific path to get there.
Qualified US Savings Bonds
Bonds are one of the best ways to save for college because, in most states, they are tax-free when redeemed. EE and I bonds are federally tax-free as long as the money is spent for higher education.
In addition to tax benefits, there is no penalty for using the bond for expenses other than education.
However, in this case, the interest earned would be counted as income for tax purposes.
Education Savings Account (ESA)
This option allows you to save $2000 per year from when your child is born until they turn eighteen. There is no way to know the growth, but at a stock rate of 10%, the $36,000 would be over $100,000 by the beneficiary’s eighteenth birthday.
The account can also be transferred to a sibling, if necessary.
Roth IRA
This option is likely the best option for most families.
Like other college savings accounts we have discussed, the Roth IRA will impact student eligibility for financial aid. Still, it has many tax advantages and few limits regarding who can use it and what it can be used for.
Not everyone can use the Roth IRA due to income limits, but it is worth looking into each year.
As of 2021, married couples earning $198,000 or less may contribute up to $6000 each per year until they turn 50. After 50, couples may contribute up to $7,000 per year.
The beauty of the Roth IRA is that it grows tax-free, and you can withdraw your contributions at any time tax-free, and earnings are taxed if withdrawn.
The reason this option may be best is that the funds can be withdrawn for any reason, so if your child opts for a career that does not require a college education, the money can be used for anything, including your own retirement.
When saving for college, you have to know the rules of the financial aid game, or you are likely to do more harm than good both for yourself and your child. So, with each investment, keep in mind the tax laws and how capital gains and income made from those investments will impact both your taxes and your child’s financial aid eligibility.
Consider the Cost of College
When applying for college acceptance, few students realize that financial aid packages include scholarships, grants, and loans.
Loans are the only financial aid option that has to be repaid.
The need to avoid crippling student loan debt that often follows graduates and their parents for 20 years or more post-graduation is what prompts parents and guardians to begin preparing for this expense early.
Since neither free tuition nor massive student loan forgiveness is likely in our lifetimes, families have little choice but to create ways to make this college goal more manageable and more accessible for their children.
Mutual funds are considered a safer investment strategy, so it is little wonder why this tool is often utilized for college savings. For the wealthiest Americans, those who are not dependent upon financial aid to pay for college, an investment in mutual funds is acceptable.
They may even work well for the most financially savvy investors because they understand how and when to make adjustments and allocations that help them avoid at least some tax implications and penalties.
Still, for most parents, mutual funds are not a good vehicle for college savings.
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Conclusion
Saving for your children’s college education is one of those gifts that few children fully appreciate until they have children of their own. However, it is a gift that must be given careful consideration due to tax implications and financial aid eligibility. Although mutual funds may work, looking into other savings and investment vehicles may prove beneficial to both parent and child.
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