Paying for College: ESA vs. 529

It’s been a while since I’ve written about college savings and the best ways to pay for college, so I thought I’d add another installment to the series.  Today I’m going to tackle a topic for parents who want to save for their children’s college using the two most common methods, the ESA and the 529.  Both are specific types of investment accounts that allow you to invest money (stocks, bonds, mutual funds, etc.) for your child’s college education and both have their pros and cons.  Today, we’ll go through the basics of each and explain some of the differences.

Why an ESA or 529?

There are all kinds of ways to save for college – everything from a piggy bank to a simple savings account to a savings bond or CD.  So why would you step into an ESA or 529?  Simply put – growth!  While both of these investment types have a greater risk than a savings account or CD, there is also a lot greater potential for growth.  If you’re starting out early (as I hope), you’ve got as many as 18 years to ride out the risks of ups and downs in the markets.

College saving with an ESA or 529 is very similar to the approach of saving for retirement using a 401k or IRA – they are LONG TERM plans.  Both of these plans also have the nice perk of being “tax advantaged,” meaning that the interest you earn from these investments is tax free (you don’t have to pay taxes on the money they earn).  Especially if you save a good amount for your child’s college, this is a big benefit!

ESA: the Basics

An ESA (which stands for “Educational Savings Account”) is a specialized savings account that allows you to save money toward a broad range of educational expenses. You can use this money to pay for things starting with Kindergarten, making it attractive for parents sending their kids to private school.  “Educational expenses” are also defined rather broadly, allowing the funds to be used to pay for things like room and board, books, computers, etc.

The negatives of an ESA are that all the funds must be used by the time the child reaches age 30 so for those who may be a non-traditional student, this makes ESAs a bad choice.  ESAs also limit contributions to $2,000 per year so if you’re starting out late in the game (maybe you have a teenager), you can’t play catch up very easily.  Beyond these two items, an ESA is a pretty simple and awesome way to save for education.

529: the Basics

A 529 plan is also a specialized savings plan that allows you to save money, but the expenses it can be used for are limited to tuition, room, board and books.  You also can’t use the money for anything except “post-secondary” education (college).  But that’s not always a bad thing.  This limitation can help keep parents from dipping into these funds prematurely and it truly focuses the saving efforts toward college.

A couple of big pluses exist for the 529.  First is its lack of a $2,000 contribution limit. Parents of teenagers or those who want to make a big one-time payment are able to be more aggressive in saving.  There is also no age limit for the beneficiary to use the funds for college – so if your child decides to travel the world for a few years, then head off to college at the age of 28, you will still be able to help him/her even past that 30th birthday when they would start their junior year.

An Example

We have a 529 plan we opened for our daughter when she was 6 months old. Why the 529?  We chose a 529 primarily because we hope to be able to save more than $2,000 per year at some point.  So far we have invested conservatively, using three different types of mutual funds.  We’ve put in $2,800 at the time of this writing and it is currently worth $3,315 – an annualized return of 8.19% per year over the three years it has been in place.  And this has been during some pretty rough times in the economy!  Tell me what bank will pay you 8% on a CD these days?

Summary

As you can see, the 529 and ESA are very similar, but each has its distinct advantages and disadvantages.  If you are a parent who is able to help your child save for higher education, don’t overlook the possibilities (both in investment growth and tax savings) of an ESA or 529. They are easy to set up, simple to keep up and will help your investment in your child’s future go a lot farther!

If you want to learn more about paying for college, check out my other two posts on the topic: “Getting Back to Basics” and “Learning and Working.”

 

 

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Common Sense Taxes: Maximize Your Tax Refund

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Thus far in this series, I’ve shared my thoughts about whether or not you should pay off your mortgage early and whether you should go for a Roth or a Traditional retirement plan.  Today I’m going to tackle the topic that most of you really care about around this time of year – how to maximize your tax refund.  Last year, the average American received a check for almost $3,000 from the IRS and this year looks to be about the same. Some got $5,000 or even $10,000 and some got even more than that, all at one time, thanks to the federal government’s generosity (ha!).  Let’s go through some ways to make sure you’re getting every penny you can and what to do when it shows up. Read the rest of this entry »

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Common Sense Taxes: Which is Better for Retirement – a Roth or Traditional Plan?

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Before I get into this, let me give a small disclaimer.  I am not certified as a retirement planning expert, so my answer comes from a common sense, real-world layman’s perspective.  Now, let’s discuss retirement!  One day in the future, most people want to celebrate a day when they don’t have to go to work any longer out of necessity and can enjoy the fruits of their labor by way of retirement.  The only way to get to that point is to save for retirement (obviously) with a long-term strategy of growing your investments to allow you to live off whatever interest they generate.  Most financial counselors agree this means you need to save at least ten times the amount of the number you’d like to live off of when you retire.  In other words, if you want $100,000 to live on when you retire, you need to have $1,000,000 in the bank to be able to make that happen.  We won’t get into the specifics of that here, but I want to bring it up because it is relevant as we consider the difference between Roth and Traditional retirement plans.  Let’s dive in. Read the rest of this entry »

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Common Sense Taxes: Should You Pay Off Your Mortgage Early?

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Usually around tax time each year I get the question about whether or not it makes sense to pay extra on your mortgage to pay it off early.  There are two sides to the argument: 1) pay it off as fast as you can so you’re out of debt, and 2) don’t miss out on the opportunity to save on your taxes by deducting mortgage interest.  Let’s break each of those thoughts down, shall we?

“Pay it Off” Argument

The folks in this camp don’t like debt.  They oftentimes can’t itemize their taxes so having mortgage interest doesn’t help them any and so they want to get rid of the debt.  This is the camp in which your grandparents likely fall and those who don’t want to deal with complicated money matters.  Their answer is simply, debt is debt and I don’t want to be in debt.

“Take the Tax Deduction” Argument

The folks in this camp are usually more sophisticated, higher income earners and thus have higher tax responsibilities.  Many times they learned some things about finance in college and so they realize tax deductions are generally a good thing because it keeps you from paying as much to the government in taxes so they do everything they can to lessen the chance they’ll owe anything come April 15.  This may include things like upgrading to more efficient appliances, buying hybrid or electric cars, claiming no dependents (sometimes referred to as “zero single”) on their W-4 so as to be sure not to owe taxes but to instead get a refund.

My Take on It

I say the IRS is a bunch of over-educated, complicated mess of people who do everything possible to squeeze every penny out of income earners they possibly can.  That is their job.  That being said, I strongly encourage people to get out of every kind of debt.  DEBT = RISK, and there is no exception to that equation.  If you read my book, you’ll see that phrase in there several times.  MIGHT you get a tax deduction for your mortgage interest – yes…sometimes.  Does the math work?  No. Let me walk you through it.

First off, you can’t get any deduction for mortgage interest if you can’t itemize (and most people can’t itemize based on the small amount of their other deductible expenses).  For those who are able to itemize, it is often because of the large amount of mortgage interest being paid, making the real benefit less than if the mortgage was only a small part of the overall deductible expenses.  But for the sake of argument, let’s assume you could itemize and get the full tax benefit from having the mortgage. That benefit gained almost never outweighs the cost in interest payments to get the deduction.  So, in VERY FEW (almost no) cases does it make sense.  Let’s go through an example.

Let’s say you have a mortgage payment of $1,200 per month and the interest portion averages out to about $800 of that (even at today’s rates that’s probably about average depending on where you fall in the amortization schedule).  That means over the course of a single year, you’ll pay $9,600 in potentially-tax-deductible interest ($800 x 12 months) on a mortgage.  If you have no mortgage, you’d lose that deduction and instead have to pay taxes on the $9,600.  If you’re in a 30% tax bracket, you’d owe the IRS $2,880 in taxes (30% of $9,600).  So…the math works out that you’d be paying $9,600 to the bank to save $2,880 in taxes.  That math doesn’t work!  Repeat the example with your own mortgage information and see if you can be the rare example where the math works.  I bet you can’t make the math work.

Summary

Call me simple, unsophisticated, or even flat stupid if you wish, but I think I’ll stick to living in my paid-for house anytime over taking on a mortgage payment.  If there is any debt I will condone it is a mortgage, but pause for a moment and think about how awesome it would be to live a life with no payments!  Don’t get stuck in the mindset of society that says you can’t own a car without a car loan or a house without a mortgage.  Pay off your mortgage early and live debt free!  I promise it is worth it.

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The Truth About Credit Cards – Part Two

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You’re back for more, huh? Yesterday I covered five lies that people believe about credit card usage. I upset some of you, but that’s okay. It’s hard to quit believing something you’ve believed for years. I totally understand that. I just hope I’ve given you something to think about – something to ponder for future spending. Let’s proceed with five more!

Myth 6: Using credit cards it the only way to build my credit.

Why do you need to build your credit? Do you plan on borrowing more money? If not, then who cares what your credit score is? My goal is to NOT borrow money, so if my credit score was 0, it would be okay.  And yes, I know some of you want to know how to get a mortgage without having good credit. Mortgages are one of the few things I don’t have issues with in regards to debt. Homes are a good thing – if you are buying a home within your means. You can get a mortgage without having a credit score. Yes, you heard me.  It’s called nontraditional credit, and it happens all the time.  Fannie Mae, FHA and VA all deal with this daily.  Want to debate the other reasons for having a decent credit score? Check out my responses to those first.

Myth 7: I’m on a 0% APR promotion, so I’m not losing any money.

Remember, these are multi-billion dollar companies. Are they making their billions because you’re playing their system and not giving them any of your money? Nope. The catch with most of these promotions is that if you’re late even once, your interest rate goes to their default (maximum) and you’re also (most of the time) penalized by being charged all the accumulated interest back to the beginning of the agreement. Yikes! That can really add up.

Myth 8: It’s more convenient to carry a credit card.

Is it really? Is it convenient to spend more money? A study was done about spenders at McDonald’s – when they used cash, their purchase averaged $4.  But when they used a credit card, they spent roughly $7. Imagine if you had that much of an increase everywhere!  In general, studies show you’ll spend about 18% more by using credit. That’s a hefty sum to pay for convenience.

Myth 9: I have to have a credit card to purchase things online or to rent a car.

Is it true that some companies won’t let you use a debit card to rent a car? Yep. Is it also true that you can say “no thanks” and take your businesses to another rental agency? YES. It’s called BUYING POWER. You have the cash, you make the choice. You can search online for a company that accepts debit cards. Ehow has a good article about that.

Myth 10: I can afford this…just not now. I’ll get a check at the end of the month.

Do you wonder how many people have gone down with the ship because of this belief? Wonder how many people bought a BIG SCREEN for the BIG GAME and then lost their job the next week? It happens a lot. You are not immune. If you can afford it at the end of the month with your bonus check then just wait until the end of the month. A few weeks won’t kill you.

Whew – now I know what pastors who preach those harsh sermons feels like.  I’m sure I’ve stepped on just about everybody’s toes and a few of you have hateful things you can’t wait to share.  But one last thing before you do – just like the pastor who preaches a sermon that steps on everybody’s toes, I’m trying to help.  I see too many people who play with snakes and get bitten.  Credit cards are dangerous.

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