Saving for College

John and Sarah are married, both 40 years old, and file jointly. They have two children, ages 8 and 12, and are in the 24% federal tax bracket. They want to save for their children's college education and have asked you for advice. They estimate each child will need $40,000 per year for four years, starting at age 18. John and Sarah can contribute $5,000 annually towards college savings. They expect an average return of 6% on their investment.

Which of the following would be the most appropriate recommendation?

Open a 529 plan and contribute the annual $5,000, investing in a balanced portfolio.
Invest the $5,000 annually in a Uniform Transfers to Minors Act (UTMA) account for each child to retain flexibility.
Use a Coverdell Education Savings Account (ESA), splitting contributions between the two children.
Save $5,000 annually in a high-yield savings account to reduce investment risk.

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Answer A - Open a 529 plan and contribute the annual $5,000, investing in a balanced portfolio.

Explanation:

A 529 plan is a tax-advantaged savings plan designed specifically for education expenses. Contributions to a 529 plan grow tax-deferred, and qualified withdrawals for education expenses are tax-free, making it a highly effective choice for college savings. Since John and Sarah expect an average return of 6%, a balanced portfolio in a 529 plan aligns well with their investment horizon, providing potential growth while managing risk.

Option B (UTMA Account): While a UTMA account does provide flexibility, it doesn’t offer the same tax advantages as a 529 plan for education expenses. UTMA accounts are also subject to the "kiddie tax," where unearned income above a certain amount may be taxed at the parents' rate, reducing tax efficiency.
Option C (Coverdell ESA): While a Coverdell ESA is also tax-advantaged, it has a maximum annual contribution limit of $2,000 per child. This limit would restrict John and Sarah’s ability to save enough annually to meet their college savings goal.
Option D (High-Yield Savings Account): A high-yield savings account offers lower risk, but its returns are generally much lower than a balanced investment in a 529 plan. With their 18-year time horizon, John and Sarah can afford some investment risk to achieve a higher rate of return.

Posted in CFP® Practice Question

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