It seems counter intuitive, that choosing the wrong kind of savings account for your child’s college fund could actually cost your child more, but that’s the world we live in – make the wrong choice, and your child may lose thousands of dollars in financial aid come enrollment time.

According to Robert Helgeson, director of financial aid for Valparaiso University in Indiana:

“If a parent has $100,000 in assets, the government is going to expect them to contribute $6,000 of it to education. If a student has $100,000 in assets, the government will expect $20,000.”

So, you can see where you stash your money is just as important as how much you stash.

According to the U.S. Department of Education, the student can have up to $3,000 saved in a checking or savings account in their name without losing any financial aid, but every dollar above that takes 20 cents away from any federally funded scholarships and grants junior would have been eligible for. After that, the money would be subtracted from federally funded loans.

Here are 3 places to safely shield your college savings without causing the loss of any aid.

529 college plans

This is perhaps the most popular method among younger parents. 529 plans are much like 401(k) or IRA plans, except you’re saving money for college instead of retirement. But the idea is the same. You contribute money to the plan, set your desired allocations for the money (choose between stock, bond and money market funds), and the money grows tax free – provided it is only used for education related expenses. An added perk to many plans is that if you live in the state that offers the plan, you can often deduct your contributions from your state income tax bill. 529 plans offer flexibility in determining the “owner” of the plan as well, since the parent can control who the beneficiary is. This means that if junior decides he’s going to the #1 party school, and he doesn’t really know what for, you can keep the funds from him until he gets his act straight.

529 plans do carry some restriction though. For example, the funds can only be withdrawn tax-free for educational expenses. Also, the funds available for allocation are limited.

UGMA and UTMA Custodial Accounts for Minors

The Uniform Transfers to Minors Act (or Uniform Gifts to Minors Act) provide a alternative methods of transferring ownership of cash and other financial assets to children who are too young to handle such assets, that may be simpler, cheaper and faster than a trust. Before the 529 plan became ubiquitous, the UGMA and UTMA accounts were often used as a means for parents and grandparents to provide savings for children and grandchildren.

According to the IRS, the first $950 in gains is tax-free, the second $950 is taxed at the child’s income tax rate and the remainder is taxed at the parent’s income tax rate. As you can see, the tax benefits are not nearly as robust as they are in a 529 plan, but the UGMA and UTMA custodial accounts place no restrictions on what the money can be used for. This can be good or bad, depending on your situation. For example, the child becomes the sole beneficiary of the assets in the account at age 18 or 21 (depending on the state you live in), so there’s no way to make sure junior spends that money on college and not a trip across Europe.

Roth IRA

The Roth IRA is an Individual Retirement Account in which you pay taxes on the contributions, but not on the withdrawals – ever. So what’s in doing in a list of college savings accounts? I’m glad you asked.

Once the child has an earned income, he can open a Roth IRA. Once the child turns 18, he has sole control of the account, so here again the parents lose control over what the money is spent on. One important restriction on the Roth is that withdrawals can only be made on the earnings after the child turns 59½. BUT, contributions can be withdrawn tax free at any time. So, if you’re looking at stashing a large sum of money for college, a Roth is a great way to shield the money from financial aid formulas and give the child a head start on retirement savings, since any money earned after the contributions will continue to grow tax free since it can’t be withdrawn until the child turns 59½.

Conclusion.

It seems that the custodial account is really a dinosaur when it comes to savings vehicles for children, but the 529 and Roth can be incredibly beneficial. If you’re a young family, with only a modest amount of money available to contribute on a steady basis, the 529 plan is probably the best choice. But if you come into an inheritance, or the grandparents want to make a one-time gift and you don’t mind the possibility of your child being able to use the money for something other than college, a Roth IRA is definitely worth a look.

Photo © by alancleaver_2000

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