According to our annual College Savings Survey, 68% of respondents have already started saving for college using a variety of different types of accounts. Perhaps because there are several options to choose from, 44% of respondents who aren’t saving say they haven’t started because they don’t have time to research their options.
If you are still undecided about the best way to save for college, this article provides information about six common accounts you can use and the biggest pros and cons of each.
Regardless of how you choose to save for college, one of the best things you can do is to save early and save often. Whatever you can put aside today will lower your child’s student debt burden in the future.
1. Mutual Funds
Mutual funds are diversified investments managed by a financial advisor or bank investment specialists. A popular choice for retirement plans, mutual funds offer the opportunity to invest your money in several different securities, including stocks and bonds.
Earnings depend on mutual fund performance and may come from capital gains, dividends, or bond coupon payments.
- You can spend the funds you save in a mutual fund on anything – cars, airline tickets, computers, etc.
- There’s no limit as to how much you can invest. There are more than 10,000 mutual funds available, with a wide variety of investment options.
- Mutual fund earnings are subject to annual income taxes.
- Any capital gains are taxed when shares are sold.
- Mutual funds assets owned by a parent will impact financial aid eligibility. FAFSA considers money transferred from mutual funds to pay for college as income.
A custodial account is a brokerage account opened by an adult on a child’s behalf. The funds are diversely invested, either in stocks, bonds, mutual funds, etc. These accounts are usually held by a parent and then transferred to the child once they turn 18, 21, or 25.
- You can spend the money saved in a custodial account on anything – cars, airline tickets, computers, etc., as long as the funds are used for the benefit of the minor.
- There is no limit to how much you can invest.
- The value of the account is removed from the donor’s gross estate.
- Earnings and gains are taxed to the minor and subject to the “kiddie tax” – where unearned income over $2,300 for certain children through age 23 is taxed at the marginal rate applicable to trusts and estates (in 2022).
- The student will gain rights to the account once he or she has reached legal age, and can use the money at their own discretion which may differ from the parent’s original intentions.
- Custodial accounts are counted as student assets on the FAFSA, which means they can reduce a student’s aid package by 20% of the account value.
One of the safest investments, U.S. savings bonds are debt securities that are issued by the Department of Treasury. Since the money is assured by the U.S. government, savings bonds are seen as a low-risk investment. Theoretically, investors are guaranteed a return, albeit a small one.
- U.S. savings bonds are federally tax-deferred and state tax-free.
- Series EE and I bonds purchased after 1989 may be redeemed federally tax-free for qualifying higher education expenses, making it the best way to save for kids college for some people.
- Bond owners are investing in interest-earning bonds backed by the full faith and credit of the U.S. government.
- The maximum investment allowed is $10,000 ($20,000 as a married couple) per year, per owner, per type of bond.
- The interest exclusion phases out for incomes between $128,650 and $158,650 (in 2022) for married couples filing jointly or $100,800 for individuals.
- If bond proceeds are not spent on tuition and fees, interest earned will be included in federal income and subject to tax.
4. Roth IRA
A Roth IRA is a retirement account that lets you contribute after-tax income to earn interest tax-free. You can withdraw the funds once you turn 59 tax-free without penalty; however, taking them out for college is considered untaxed income to the beneficiary.
- Contributions can be withdrawn at any time for any reason.
- The normal 10% early withdrawal penalty on earnings is waived when the funds are spent on qualified higher education expenses.
- There is a broad range of investment options available.
- The value of retirement accounts is not counted as an asset on the FAFSA.
- In 2022, the maximum investment allowed is $6,000 ($7,000 for taxpayers 50 and over).
- Only married couples earning less than $214,000 (in 2022) or individuals earning less than $144,000 may contribute the maximum amount.
- Married couples earning $214,000 or more are ineligible to contribute ($144,000 for individuals).
- Withdrawals from a Roth IRA to pay for college are considered base-year income on the FAFSA.
Previously known as the Education IRA before 2002, the Coverdell Education Savings Account is similar to the 529 plan in that they permit tax-free interest earnings and withdrawals for qualified educational expenses. Unfortunately, they’re not available to every family and have lower maximum contributions than other college funds for kids.
- Coverdell Education Savings Accounts (ESAs) you can take advantage of tax-free withdrawals to pay for qualified higher education expenses and also K-12 expenses (up to $10,000 per year).
- There is a broad range of investment options available, including the ability to self-direct your investments.
- The value of a Coverdell ESA account is counted as a parent asset on the FAFSA, no matter whether a parent or dependent student owns it.
- The maximum investment allowed is $2,000 per beneficiary per year, combined from all sources.
- Contributions have to be made before the beneficiary turns 18, and the account can only be used until they turn 30.
- Only married couples earning less than $220,000 or individuals earning between less than $110,000 can contribute.
6. 529 plan
A 529 plan is a popular type of education savings account that offers both federal and some state tax benefits when funds are used for qualified education expenses. Earnings and withdrawals are completely tax-free when you use the money for college.
- Withdrawals spent on qualified higher education expenses and up to $10,000 per year in K-12 tuition avoid federal income and capital gains tax, and some states offer additional state tax benefits.
- Depending on which plan you use, maximum investments can exceed $500,000 over the life of the account, and deposits up to $16,000 per year per individual will qualify for the annual gift tax exclusion.
- There’s also an option to treat a contribution up to $80,000 in one year as if it were made over five years to shelter a larger amount from taxes.
- 529 plans receive favorable financial aid treatment: accounts owned by dependent students are treated as parent assets and nothing has to be reported on the FAFSA when the funds are withdrawn to pay for college.
- Earnings are subject to income tax and a 10% penalty if the withdrawal is not spent on qualified education expenses.
- Investment strategies available are limited to what’s offered by the program.
- Withdrawals from accounts owned by someone other than the student or their parent have to be added back to the student’s income on the following year’s FAFSA and can reduce aid eligibility by as much as 50% of the amount of the distribution.
Wondering how your 529 plan may impact financial aid? Use our Financial Aid Calculator to estimate the expected family contribution (EFC) and your financial need.
How to Decide Which Plan to Choose
With so many college savings options, how do you best choose the right account for your child or grandchild’s college education? Here are some questions to ask and corresponding plans that might be a good fit:
Do you plan to use the funds only for college expenses?
529 plans offer the most tax benefits for your funds; however, you’ll face penalties if you use the funds for anything else.
Do you prefer to use the funds for other expenses?
If you anticipate the need for expenses outside of college, like a car or rent, custodial accounts and mutual funds allow you the flexibility to do so without incurring penalties.
Do you plan to fund more of your college education with federal financial aid?
If you’re depending on financial aid, you need to be cautious about which accounts you make withdrawals from. Any consideration of income for the college student can disqualify them from certain financial aid.
How much do you plan to save for college?
Certain types of accounts have low contribution or income limitations that will limit how much you can save for college. For example, if you choose to save with a Coverdell ESA, you can only contribute $2,000 annually and must have income under $110,000 ($220,000 for married couples).
Tips to Complement Your College Savings
Have you set up a couple of educational savings accounts, but still want to learn more about how you can maximize savings? Check out these tips:
- Apply for Scholarships: Some organizations and schools offer full-ride scholarships to cover all of your college expenses. But, don’t let that deter you from applying to lower-value scholarships — those can add up too!
- Work during the Summers: Every little bit counts. You can also find a part-time job during the school year, but the summer is the perfect time to work so that you can focus more on your studies throughout the school year. For even more flexibility, you can sign up to babysit, walk dogs, or more with a platform like Care.com.
- Get AP Credits: AP courses in high school help you save on the costs of credits in college. If there is a community college nearby, dual enrollment is a great option too.
The best way to save for college might look different for each family, but one truth remains: it’s never too early to start.
Whether you prefer investment accounts with flexible spending or can commit to solely using funds for educational expenses, there are college savings options available to you.