Investments that are owned in the parent’s name

A parent can always save for a child’s college education by making investments that are owned in the parent’s own name. This can be a desirable approach, especially if a parent is not sure whether a child will go to college, or if a parent wants to retain the ability to use the money for other purposes. Many parents choose tax-advantaged investments, such as municipal bonds, which seek to provide federal tax-free income. As a planning strategy, when it comes time to pay for college, an investment may be gifted to the child, who can then sell the investment to cover college costs. The capital gains incurred on such a sale will be taxed at the child’s tax rate, rather than the parent’s.

Other investment options in the parent’s name include:

Withdrawals from Traditional or Roth IRAs can be made to fund education expenses. These withdrawals are typically subject to tax, but not penalties, when used to pay qualified education expenses. Roth IRA withdrawals are tax free up to the basis in the account and then earnings are taxable, Of course, making IRA withdrawals to pay college expenses will impact a person’s retirement savings.

Loans from a 401(k) plan are another way some persons pay for a child’s education, if they participate in a 401(k) plan that permits loans. Amounts borrowed from a 401(k) plan can be used for any purpose, not just educational expenses. When a person borrows from a 401(k) plan, the loan must be repaid. People often think that repaying these loans is equivalent to repaying themselves, since the loan was made from their personal 401(k) account. However, a couple cautionary points should be kept in mind: First, when repaying a loan, many 401(k) plans require the person to suspend regular contributions to the person’s 401(k) account. This generally will have a detrimental effect on the value of the account at the person’s retirement. Second, if the employee is laid-off, changes jobs or becomes disabled, the outstanding loan amount generally must be repaid right away. If the loan is not paid in this instance, the unpaid loan balance must be treated as taxable income, and a 10% penalty for early withdrawal will also apply.

EE Savings Bonds have certain features that are designed to encourage their use for college education expenses. Specifically, savings bond interest is excluded from taxable income to the extent that the redemption amount is equal to or less than the amount of tuition and fees paid to an eligible educational institution for the benefit of the bond owner or the bond owner’s spouse. To qualify for this tax exclusion, the money must be used for qualified post-secondary education expense and the taxpayer’s income must be below certain dollar amounts. (Note: the exclusion from taxable income begins phasing out at higher income levels.)