According to our College Savings Survey, 68% of respondents have already started saving for college using various accounts. Perhaps because there are several options, 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 deciding 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 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 beneficiary per year in K-12 tuition avoid federal income and capital gains tax, and some states offer additional state tax benefits.
- Qualified education expenses include tuition and fees at thousands of colleges, universities, and other institutions, as well as apprenticeship programs. Books, room and board, computers, and many other expenses required by a college for attendance are also included.
- Depending on which plan you use, maximum investments can exceed $500,000 over the life of the account, and deposits up to $18,000 per year per individual (in tax year 2024) will qualify for the annual gift tax exclusion.
- There’s also an option to treat a contribution of up to $90,000 in one year as if 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by dependent students are treated as parent assets, and nothing has to be reported on the FAFSA when the funds are withdrawn to pay for college.
- Beginning in 2024, unused funds in a 529 plan may be rolled over to a Roth IRA tax-free under certain circumstances.
- 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.
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. More than 10,000 mutual funds are available, with a wide variety of investment options.
- Mutual fund earnings are subject to annual income taxes.
- Any capital gains are taxed when you sell shares.
- Mutual fund 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.
Under UGMA/UTMA guidelines, Custodial Accounts are brokerage accounts opened by an adult for a child. A parent usually holds these accounts, which transfer to the child once they turn 18, 21, or 25, depending on state regulations. They allow for diverse investments in stocks, bonds, mutual funds, etc. Ideal for family members seeking to contribute to a child’s college costs, you can use these accounts to cover expenses beyond just college tuition.
- You can spend the money saved in a custodial account on anything – cars, airline tickets, 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 $2,500 (in 2023) for certain children through age 23 is taxed at the parent’s rate.
- The student will gain rights to the account once they have reached legal age and can use the money at their 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 issued by the Department of Treasury. Since the U.S. government assures the money, savings bonds are considered 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 $137,800 and $167,800 (in 2023) for married couples filing jointly or at $106,850 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 personal finance tool used for retirement that offers tax advantages. However, it isn’t a great college savings tool. Its contribution limits may not cover the costs of a four-year, in-state college education and student loan debt. Withdrawals could impact financial aid eligibility, and unlike 529 plans, contributions don’t qualify for tax deductions. Also, a Roth IRA requires regular monitoring, like a checking account. So, it’s best to consult a financial advisor for a suitable college savings strategy.
- Contributions can be withdrawn at any time for any reason.
- The typical 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.
- For 2024, the maximum investment allowed is $7,000 ($8,000 for taxpayers 50 and over). For 2024, the max was $6,500.
- Only married couples earning less than $230,000 (in 2024) or individuals earning less than $146,000 may contribute the maximum amount.
- Married couples earning $240,000 or more are ineligible to contribute ($161,000 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.
The Coverdell Education Savings Account (ESA), previously known as the Education IRA before 2002, is a tax-advantaged college savings plan designed to facilitate a child’s college education. Offering tax-free interest earnings and distributions for qualified educational expenses, it’s a viable option for families planning for future college costs.
However, unlike other college savings plans, the Coverdell ESA has certain eligibility restrictions and lower maximum contribution limits. These factors limit the account’s effectiveness in covering the total cost of college, particularly for families with multiple students or those facing high tuition rates.
- Coverdell Education Savings Accounts (ESAs), you can use tax-free withdrawals to pay for qualified higher education expenses and K-12 expenses (up to $10,000 per year).
- A broad range of investment options is 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 must 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 education 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 and taxable investment accounts 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 depend on financial aid, you must be cautious about which accounts you withdraw from. Any consideration of income for college students can disqualify them from specific 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 some educational savings accounts but still want to learn more about how you can find more money for school? Check out these tips to find other ways to help pay for school:
- Apply for Scholarships: Some organizations and schools offer full-ride scholarships to cover your college expenses. But don’t let that deter you from applying to lower-value scholarships — those can add up, too!
- Find Grants: You can find and apply for grants, which is essentially free money to go to school. This allows you to reduce 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 a community college is nearby, dual enrollment is also a great option.
- Consider Loans as a Last Resort: Student loans can be helpful to pay for anything that all of the other combined options can’t cover. They can be expensive, though, so exhausting all other options first is important.
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, college savings options are available.
Contributors need to assess their financial capacity, considering factors like interest rates, annual contribution limits, and potential penalties for non-educational usage.
The choice between in-state or out-of-state colleges can also significantly impact the total cost of education, making it crucial to plan accordingly. Tax benefits offered by plans like 529s can be a substantial advantage, but they also come with restrictions that could limit flexibility in spending.
Frequently Asked Questions (FAQs)
What is the best way to save for college?
There are plenty of ways to save for college, but for many families, the benefits of a 529 plan outweigh other options. You can invest money into the market while tax-free withdrawing funds for college expenses.
Is a 529 plan 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 saving for education.
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.
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. Saving early and often helps most parents set aside more money to reach their goals.