According to our 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.
1. 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owned by dependent students are treated as parent assets and nothing has to be reported on the FAFSA when the funds are withdrawn to pay for college.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.
Best For: Everyone. This is a great way to save for college or to supplement other potential savings. It offers nice tax breaks and provides plenty of options to grow your total savings. You can enroll now by checking out our best 529 plans.
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.
2. 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.
Best For: Growing your total wealth or for people wanting to spend the money on nonqualified expenses at college such as a car.
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.
Best For: Minors who need help with college savings and may need to spend the money on extra expenses that are outside the normal course of college students.
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.
Best For: Saving money in a virtually risk-free environment that doesn’t need to grow much.
5. Roth IRA
A Roth IRA is a retirement account that lets you contribute after-tax income to earn interest tax-free but it isn’t a great college savings tool. 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.
Best For: Saving for retirement and not college.
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 less than $110,000 can contribute.
Best For: Long-term savers that don’t need to save a lot for college.
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 an 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 find more money for school? Check out these tips in order to find other ways to help pay for school:
- 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!
- Find Grants: You may be able to find and apply for grants, which is essentially free money to go to school. this gives you the opportunity to cut down on what you’ll pay since the money can be applied directly to what you owe at the school.
- 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 College Credit During High School: AP courses in high school can help you save on the costs of credits in college. If there is a community college nearby, dual enrollment is a great option too.
- Consider Loans as a Last Resort: Student loans can be helpful to pay for anything that all of the other options combined aren’t able to cover. They can be expensive, though, so it’s important to exhaust all other options first.
The Bottom Line
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.
Frequently Asked Questions (FAQs)
What is the best way to save for college?
There is plenty of ways to save for college but the best way is to probably utilize the benefits of a 529 plan. You can invest money into the market while withdrawing funds for college expenses tax-free.
Is 529 plans a good way to save for college?
Yes, a 529 plan is a great option to save enough money for college. There are tax benefits that are hard to compete against by the other college savings options because it was created to benefit those attending school.
What is a good amount to save for college?
The right amount to save for college is going to depend on a number of factors such as where you attend school, what your degree is in, and whether you plan on having a job while you go to class. With a 529 plan, you can save as much money as you can and grow that fund without worry. After 15 years the plan will be able to be rolled over to a Roth IRA account.
How much do most parents save for college?
The amount of money saved for college varies greatly by the parent’s income and how early they’re able to start saving for school. Most parents we hear from end up not saving as much as they feel they should have saved. Many parents don’t save enough to pay for more than one year of school because they underestimate the cost of college and it continues to go up.