Milestone 7: Prefund Kids’ Education Expenses
Congratulations on making it through the first six milestones on our Next Dollar Roadmap:
- Starting Point: Creating Your First Budget
- Milestone 1: The Uh-Oh Fund
- Milestone 2: Take Advantage of Your Employer Match
- Milestone 3: Pay Off Toxic Debt
- Milestone 4: Fully Funded Emergency Fund
- Milestone 5: Save 15%-25% of Your Income in Tax-Advantaged Retirement Accounts
- Milestone 6: Save for Flexibility in Bridge Accounts
- Milestone 7: Prefund Kids’ Expenses
- Milestone 8: Pay Off Remaining Debt
- Milestone 9: Total Financial Independence
As I mentioned in the previous post about Saving for Flexibility, Milestones six through eight are arranged in a generally optimal order but can be altered to suit your personal goals.
In fact, my wife and I started work on Milestone 7: Prefund Kids’ Education Expenses, before we began contributing to a taxable investment account.
With that said, there are a couple of very good reasons saving for the future education needs of others comes so late in the Next Dollar Roadmap.
The first and primary reason is that you have to take care of your own needs first.
As appealing as financial assistance might be to your kids, it’s probably not quite as desirable as having you living in their basement after you retire because you can’t afford a place of your own.
Do yourself and your kids a favor. Prioritize your retirement saving over their academic expenses.
A second reason is that there is no shortage of financial assistance available for students who need money for school. Between scholarships, financial aid, and student loan programs, if your loved ones need money for school, they will probably be able to find it somewhere.
Conversely, I am not aware of anyone who provides retirement loans to those who failed to save enough to take care of themselves. If you have to come up short somewhere, it’s best if it’s not in your retirement accounts.
With those clarifications in place, if you want to set aside some money to support the future educational endeavors of your kids or other friends and family then there are several approaches you can take.
I’ll cover several strategies for prefunding education needs in this post and explain several pros and cons of each one.
529s
By far, the most commonly used account for education savings is the 529 Savings Plan.
A 529 plan provides an opportunity to save and invest for future educational costs while providing the benefits of tax-free earnings and withdrawals if distributions are used for a qualified education expense.
Many tend to think of it as a Roth IRA for school.
Annual contributions are limited to the annual gift tax exclusion ($19,000 in 2025), but you can preload an account by directing up to five years of contributions at one time.
While earnings and withdrawals from 529s are tax-free, contributions are taxable at the federal level but may receive a state income tax break depending on where you live and what plan you contribute to.
When you open a 529 you must name a beneficiary but you can change the named beneficiary to close relatives of the initial beneficiary later if you so choose.
This provides some flexibility in case you over-save for a beneficiary who doesn’t use any or all of the money.
And flexibility is certainly something to keep an eye on when using a 529 plan because distributions that aren’t used for educational expenses are subject to income tax and a 10% penalty.
Generally speaking, you want to avoid overfunding a 529 if possible due to the potential for a 10% withdrawal penalty.
Of course, since many people use 529s to save for college it can be challenging to decide how much to contribute since you won’t know where your beneficiary will go to school or how much that school will cost until they need the money.
Personally, our approach has been to aim to save around 80%-90% of the cost of attendance for an in-state public institution, cost-adjusted for inflation. We will make up any shortages out of pocket or using financial aid.
Roth IRAs
Roth IRAs are designed to serve as a retirement savings account, but there are some exceptions the IRS provides that allow account owners to make withdrawals for other needs.
Among these exceptions is the ability to use Roth IRA funds for qualified education expenses, penalty-free.
Since 529s and Roth IRAs work similarly from a tax standpoint and Roth IRA distributions offer a much higher degree of flexibility, many consider using a Roth IRA to fund college for their kids or other eligible loved ones.
(I’m not going to get into a lengthy explanation of how Roth IRAs work here. If you want to know more, check out my post about IRAs.)
I’m not a huge fan of this approach for a few reasons.
First, your Roth IRA money is for retirement. Like I’ve already said, you need to prioritize your retirement over your kid’s education for their sake and yours.
Second, if you live in a state that offers a tax deduction for 529 contributions, you’d be passing up a tax break by using your Roth IRA.
Perhaps most importantly, any earnings from your Roth IRA that you use for education will be subject to income tax, meaning there isn’t much of a tax benefit left for these dollars.
The contributions were taxed going into the Roth, so if the earnings are also taxed, then the entire transaction is taxable while you’ve also reduced the amount of room you have in your Roth for retirement savings.
I would not recommend using a Roth IRA to fund college unless you don’t have another good option available. Even then, try to limit the use to contributions only so you can at least preserve the benefits of tax-free growth.
Prepaid Tuition
Once very popular, prepaid college tuition plans allow participants to pay for future college costs at today’s rate. There are currently only 9 states (Florida, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia, and Washington) still accepting new applicants for these plans.
Prepaid college plans are actually a type of 529 (except for one in Massachusetts) that allows participants to purchase a number of semesters or fractional units of future education.
The prices in these plans are based on current average tuition rates at a select group of colleges. This means any earnings and withdrawals are tax-free as long as they are used for qualified education expenses.
Prepaid plans can be combined with standard 529s and Financial Aid treatment for prepaid plans is the same as standard 529 plans.
In most cases, participants will have to choose a private or public option when setting up the account, but this can be changed later. Changes may result in a shortfall or overage in savings, but there are processes for mitigating that too.
One drawback of prepaid plans is they normally only cover tuition and fees whereas standard 529s cover tuition, fees, computers, internet, supplies, fees, books, and some other expenses.
UTMA/UGMA Accounts
If you’re running out of places to efficiently transfer money to your kids, you may want to consider the Uniform Transfer to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA).
UGMAs and UTMAs are custodial accounts that allow participants to transfer money or assets to minor beneficiaries.
The accounts belong to the child but are controlled by the custodian until the child reaches the age of majority for your state (anywhere from 18-21 depending on where you live).
Unfortunately, UGMAs and UTMAs are not as beneficial from a tax perspective as 529 plans. Contributions are made with after-tax dollars and can be made up to the annual gift tax exemption of $19,000 ($38,000 per couple).
The first $1,250 of earnings (that is, interest or dividends from investments) in the account is tax-free. The next $1,250 is taxed at the child’s income tax rate.
Anything beyond the first $2,500 of earnings is taxed at the parent’s income tax rate until the child reaches the age of majority for your state.
Any earnings received by the recipient after reaching the age of majority would be taxed at their income tax rate because they have complete control of the account at this point.
For example, let’s assume Susie Q. has $20,000 in an UGMA account. The account earns 10% ($2,000) in 2025 and Susie is in the 12% tax bracket. Susie will owe 12% income tax on $750 ($2,000-$1,250), which totals $90.
Let’s also assume Susie’s friend Jack has $50,000 in a UGMA account which also earns 10% in 2025. Like Susie, Jack is in the 12% bracket, but Jack’s parents are in the 32% bracket.
Jack receives $5,000 from the investments in his UGMA. As a result, $1,250 is tax-free, $1,250 is taxed at 12% (this is $150), and the remaining $2,500 is taxed at his parents’ rate of 32% ($800). All told, Jack pays $950 ($150 + $800) when income taxes are due next April.
Since UGMA/UTMA accounts are owned by the beneficiary, FAFSA reduces the student’s aid eligibility by 20% of the asset’s value. 529s are viewed as the parent’s asset which reduces aid by only 5.64% of the asset’s value.
There are no spending restrictions on UGMA/UTMA account dollars. When combined with the limited tax benefits, this feature of UGMA’s/UTMA’s makes them a useful strategic tool for your financial plan.
Just Give Your Kids Cash
Another option, which may or may not cross your mind, is to simply begin giving sums of money to your children.
In 2025, you are allowed to give up to $19,000 to any other individual, completely tax-free and without any obligation to notify the IRS. This is known as the Annual Gift Tax Exclusion.
If married, you and your spouse can combine your Annual Gift Tax Exclusion and give up to $38,000 to any one person.
Any gifts over this amount in a calendar year are subject to reporting to the IRS and will count against your Lifetime Estate Tax Exemption. In 2025, the Lifetime Estate Tax Exemption is $13.99M per person.
It’s helpful for me to think of Gift Tax Exclusions and Lifetime Exemptions as the IRS giving you two empty vessels in which to shelter gifts from taxes in your lifetime. The annual exclusion is a bucket that empties each calendar year, but the lifetime exemption is a swimming pool.
Fill up the bucket in a year, and the excess spills into the pool. Fill up the pool and you’ll owe gift taxes (while you’re living) and estate taxes (after you die) on everything else that doesn’t fit.
Let’s walk through an example.
Suppose Jack and Susie grow up and get married. They eventually have two kids of their own and are doing so well financially that they decide to gift $50,000 to each child on their 21st birthday.
Jack Jr. is up first and receives his $50,000 from Mom and Dad on his birthday. The first $38,000 of the gift is excluded from Gift Tax reporting because Jack and Susie use their annual exclusion amounts.
The next $12,000 is counted against Jack and Susie’s Lifetime Exemption of $27,980,000. As a result, when Jack and Susie die, only the first $27,968,000 will be exempt from estate taxes.
In summary, there is a gift tax, but you have to give away a lot of money before you trigger it. Givers pay the gift taxes; recipients do not.
With all of this said, I would proceed cautiously before giving loads of cash to a young person.
For the right type, this money could be used responsibly and provide a tremendous opportunity to advance their financial plans by years.
But there’s also the type that will allow such a gift to sap their motivation for achievement in life.
Be sure your children can handle such a gift before delivering such a large sum of cash.
We’ll cover giving in further detail in Milestone 9.
Next stop, Milestone 8: Pay Off Any Remaining Debt
