If you are a parent, you have likely considered saving for your child to attend college to help mitigate future student loan debt. With multiple options to save in advance, it might be unclear which savings plan is best for your family. Here are the top six education savings accounts and how to develop a strategy to get started.
A 529 plan is probably the most common and well-known college savings plan, but rates, fees, and rules can differ when considering this pathway. Simply put, a 529 plan is an investment vehicle designed for college savings that provides some tax advantages. Within the 529 plan, though, there are two types to choose from: education savings plan and prepaid tuition plan.
Education Savings Plan
With an education savings plan, you can open an investment account to save after-tax dollars that can then grow tax-free for the beneficiary’s future college expenses. While similar to a Roth IRA that can be used for retirement savings, a 529 plan allows higher contributions. The funds can be used for qualifying educational expenses, and withdrawals are not taxed either. Savings plan details can vary from state to state and may offer credits to state residents. However, the funds can still be used should the student decide to attend college in another state.
Prepaid Tuition Plan
The concept behind the prepaid tuition plan is that you prepay to “lock in” the current rates. Since the cost to attend college goes up annually, locking in a rate far in advance could save a significant amount of money over time. However, because these plans are such a bargain, some states are doing away with them. In fact, only nine states offer these prepaid tuition options for new enrollees.
Pros and Cons of 529 Plans
It is always helpful to weigh the pros and cons of any investment before pursuing it. The benefits of 529 plans include the ability to grow income tax-free with high contribution rates. While restriction to educational expenses could be considered a con, one pro is that the beneficiary of the savings can change. The primary con of this type of account is that it can only be used for educational purposes.
Traditional Savings Account
Setting aside any amount of money for college is better than none, which is why some Americans opt for a traditional savings account to save for college expenses. One rule of thumb you can use is to multiply the child’s current age by $3,000 for an in-state, public, four-year college, $5,000 for an out-of-state, public, four-year college, and $7,000 for a private, nonprofit, four-year college. You can get an idea of what this looks like with this helpful calculator.
Pros and Cons of a Traditional Savings Account
This approach also comes with pros and cons.
On the pro side, a savings account is a safe place to keep your money, especially since most banks are protected by the Federal Deposit Insurance Corp. You can earn interest as well, although even the highest-yielding savings accounts in 2020 only earn about 2% APY. Another plus is that you have the flexibility to use the money however you decide to, without it being strictly committed to educational expenses.
On the con side, the returns on the income are low and do not account for inflation. Also, few tax benefits exist for traditional savings accounts compared to other savings options.
A Roth IRA is similar to a 529 plan in that contributions can be made in after-tax dollars and withdrawals can be made tax-free. Investors of Roth IRAs can take the funds out penalty-free if they are at least 59 ½ years old. An exception can be made to take out funds earlier for educational expenses as long as the account has been opened for five years.
The drawbacks of using Roth IRAs to fund college expenses can occur if you start saving too close to when college begins. You can only contribute $6,000 annually (or $7,000 if you’re 50 or older), and the average college tuition cost for a public, four-year, in-state school is over $21,000. Another downside is that the money taken out from this type of account will be considered income, which can reduce your child’s ability to get aid in the future.
Coverdell Education Savings Account
A Coverdell Education Savings Account is very similar to a 529 savings plan. The key difference is the flexibility in what the savings can be used to cover. For example, with a Coverdell ESA, withdrawals can be made to cover K-12 expenses, like uniforms and tutoring programs. The biggest drawback of this option is that parents can only contribute up to $2,000 per year. Contributions also must stop when the child turns 18 and must be withdrawn before they turn 30.
CDs and Savings Bonds
A CD is a Certificate of Deposit, which can be used to lock away a portion of your money to yield a return from an interest rate. Savings bonds are similar savings vehicle that offer a small profit. Both are considered safe and low-risk investments. However, the amount of interest that can be earned is minimal, making them not the ideal choice for college savings. They can work better when used in conjunction with other savings options. Certain types of savings bonds are even excluded from the education tax. These can make them beneficial when used for education savings, but there are some restrictions.
Trust accounts can be made in the form of the Uniform Transfers to Minors Act (UTMA) or the Uniform Gift to Minors Act (UTGA). These accounts can be built up and turned over to the beneficiary at the “age of trust termination,” which is typically between 18 and 21, depending on the state. It could be considered a pro and con that this type of account does not have to be used for education since the young adult will have full control over how to use the money.
Tax rules regarding trusts can benefit the donor if they wish to relieve their estate’s tax burden, but the beneficiaries should also be prepared to pay income taxes on their trust funds. Another drawback is that this income could reduce a child’s eligibility for financial aid.
Developing the Best Strategy
With one-third of the recommended college expenses expected to come from savings, you can consider which strategy works best for you and your family. Keep in mind that the next third can come from current income, including funds from grants and scholarships, and the final third from future income in the form of student loans to be paid back.
When strategizing for college savings, you may find that a combination of plans works best for your family. Consider the speed in which you can save, how far in advance you can begin saving, and the projected cost of school. Also, keep in mind that grandparents can contribute an annual gift tax exclusion.
What If I Have Not Started Saving?
If you have children who are approaching college years, and you are concerned that you did not save enough, there is no need to worry. There are plenty of alternatives to make attending college a realistic option for your soon-to-be student. Grants and scholarships are available that do not need to be repaid. There are also work-study programs. Additionally, the federal government offers student loans with flexible repayment options, while private lenders can also provide student loans.
If you have any questions about saving for college, or you want to explore the other options for your soon-to-be college student, check out the abundance of resources at College Finance. We take pride in helping aspiring students and their parents find the best pathway to ensure that college is a realistic option for them and want to help you get the most out of your college investment.