What is the Right Way to Save?
By Harold Simansky
Educational Investment Advisor
In the last few articles I talked about how much college is going to
cost and how much financial aid your student is likely to get. If you
don’t yet have a specific number in mind as to how much you should
save, you should. There are numerous calculators on our site
that can walk you through that process.
Of course, knowing this number is only the first step. Now you have to
figure out how you are actually going to save the money you will need.
Here you generally have two choices: taxable accounts and tax-advantaged accounts.
Taxable accounts usually refer to traditional savings
vehicles on which you pay taxes every year. They include:
- Mutual funds
- Certificates of deposit
With tax-advantaged accounts, you do not have to pay taxes
on any of the earnings on the account (i.e., the
capital gains, dividends or interest earned on your
investments.) Tax-advantaged accounts include:
Coverdell Education Savings Accounts
529 Savings Plans
Custodial Accounts, also known as UGMA/UTMA accounts
The best choice for most people saving for education
is likely to be a tax-advantaged account because you’ll end up
with more money. Putting $1,000 in a tax-advantaged account
on the day your baby is born will yield nearly $4,000
18 years down the road, assuming an 8 percent rate of
return. Investing $1,000 in a taxable account would
bring less than $3,300 over that same number of years,
assuming a 15 percent tax rate.
Before you pour all your money into a tax-advantaged account,
however, be warned. If you don’t end up using the money
for its designated purpose – either education or retirement
– not only will you pay taxes on the money but a 10 percent
penalty to boot. So if you are not certain the money
you save will definitely be used for education,
a taxable account is likely your best choice.
Before You Make That Choice, However...
Let’s first answer the all-important question:
"How will saving affect the financial aid we get?"
We can’t emphasize this point enough: Keep as little
savings as possible in your child’s name. This is because
those accounts will do the most harm when you go
looking for financial aid. Accounts in a parent’s name
will affect the amount of financial aid far less.
Accounts in a grandparent’s name or someone else’s name
will have almost no effect.
Based on this information, and because of quirks
in the rules about who the account owner is deemed to be,
the different accounts will have the following effects
on financial aid:
Greatest Reduction in Level of Aid
Custodial Accounts (UGMA/UTMA)
U.S. Savings Bonds, if issued in student’s name
Traditional investments, if in student’s name
529 Savings Plans owned by parents
Coverdell Education Savings Accounts with parent as "responsible individual"
U.S. Savings Bonds owned by parents
Traditional investments owned by parents
Smallest or No Reduction
Retirement accounts held by student or parent
529 Savings Plans owned by grandparent or other person for the benefit of the student
Direct tuition contribution, if someone else pays
the student’s tuition. This has no effect on financial aid
and is also fully exempt from any gift tax restrictions.
(Caveat: Such a gift tax exclusion only applies
to tuition payments, not payments for room and board.)
Based on both tax ramifications and financial aid impact,
you can start deciding which plan is best for you.
We start doing that and making recommendations
in Article Five.
Article #3 -
Financial Aid: A Primer
About the Author
Harold Simansky is the founder of Educational Investments, LLC, (www.educationalinvestments.com
a Registered Investment Advisory firm focused on helping families save for
education. His book, College Costs How Much?! The Workbook to Help You Save for
, which explains the financial aid process, is available at
. You can send
him an e-mail at Harold@edinv.com