The cost of college has more than doubled since 1964, leaving many students buried in student loans. To help your child start off their adult life without a haunting mountain of debt, it’s worth considering which college savings plans can effectively help you save for their education. Of course, like all things money, it’s best to start as early and let time and compound work its magic, but where should you be putting the money? 529 plans are helpful, primarily due to the tax savings, but there are a few things you should know.
What is a 529 plan?
A 529 plan, also known as a “qualified tuition plan,” allows you to put money away for future education expenses without paying taxes on its growth. As long as the money is taken out to pay for “qualified higher-education expenses,” it won’t ever be taxed. These plans are sponsored by state governments, state agencies or educational institutions.
Some key benefits of 529 plans are they enable tax-free growth, allow for tax-free withdrawals when used for qualified higher-education spending, and can earn you state tax deductions on contributions.
Types of 529 plans
Prepaid Tuition Plans
A Prepaid Tuition Plan lets you prepay the costs of units and credits at participating universities and colleges (often in-state and public) at the current prices. If the prices increase by the time your child starts studying, you save on the costs. A Prepaid Tuition Plan locks in the price of a set list of schools ahead of time.
As for the drawbacks, the Prepaid Tuition Plan doesn’t allow you to use the funds for K-12 school tuitions, and in most cases, the savings can’t be used to pay for room and board expenses when your child goes to college. Additionally, most Prepaid Tuition Plans come with residency requirements and the plan may not be guaranteed by the federal or state governments, which put your funds at risk.
Education Savings Plans
With Education Savings Plans, your money goes into an investment account where it can grow tax-free. Investment options often include a principal-protected bank, exchange-traded fund (ETF) portfolios and mutual funds. The amount of risk you are willing to tolerate will determine your approach.
The Education Savings Plan differs from the prepaid plan in that the “qualified higher education expenses” are more inclusive. You can use the account to pay for tuition and fees along with room and board, books and supplies, computers and required equipment. Additionally, as of 2018, you can pay for up to $10,000 per year per beneficiary for tuition fees at any K-12 school.
Education Savings Plans also commonly lack the residency restrictions of Prepaid Tuition Loans, meaning that you can live in one state and contribute to a plan in another while sending your child to college in another. The bottom line is more risk but much more flexibility.
For those who know their beneficiary wants to stay in-state and who prefer to limit their risk, the Prepaid Tuition Plan may be a good fit. But, more and more so the Education Savings Plan is the choice I’ve seen made.
This type of account has really made a great impact on the ability of many families to grow a bigger pool of money for their children
What can I use the 529 plan for?
The Prepaid Tuition Plan covers college tuition but does not cover the costs for elementary and secondary schools, or anything else really. On the other hand, Education Savings Plans cover more expenses, including tuition fees, accommodations, food, books, materials and K-12 tuition fees at public and private schools. If the money is withdrawn and used for a non-qualified expense, you can generally expect to pay state and federal income taxes and an additional 10% federal tax penalty on your earnings.
How to optimize the 529 plan
529 plans offer tax-free growth, but only when you use the funds to pay for educational expenses that are allowed within the plan’s rules. If the money is withdrawn for non-qualified expenses, it will be taxed. So, it’s worth calculating future education expenses and planning your savings accordingly. You can also roll over the remaining balance from one child to another if the amount is not used by your initial beneficiary.
Keep an eye on costs such as administrative and enrollment fees associated with Prepaid Tuition Plans, as well as maintenance and management fees for the Education Savings Plans. Many states offer Education Savings Plans which you can invest in without paying additional fees if you are a resident of the state that is sponsoring the 529 plan.
The ideal situation is to open an account when the beneficiary is born, that will allow approximately 17 to 19 years of account contributions and growth within the account to maximize before needing the funds for higher education.
Other ways to save for your child’s education
Although a 529 plan is a highly recommended strategy to save for college, there are a few other college funds for kids to consider.
A Roth IRA is a popular type of tax-advantaged retirement savings account, but it can also be used as a college savings vehicle. Like 529 plans, you contribute after-tax money, and any investment gains can be withdrawn later tax-free — most often after you’re 59 and a half years old, for retirement.
However, Roth IRAs also allow you to take out funds tax- and penalty-free to pay for qualifying educational expenses after five years. That makes it an appealing way to hedge your bets: if your child doesn’t go to college, you can still use the funds for your retirement.
However, there are income and contribution limits. For the 2019 tax year, you can only contribute $6,000 per year ($7,000 if you’re over age 50) and single taxpayers earning more than $137,000 per year ($203,000 for married couples) are not eligible.
Coverdell Education Savings Account
Similar to 529 college plans, a Coverdell Education Savings Account (ESA) is generally tax-advantaged if the money is used to pay for educational expenses. And, like a 529, it’s also considered your asset — not your child’s — so it will have less impact on your child’s chance of getting federal aid.
Unlike a 529, Coverdell ESAs can be used to cover any educational expenses, including K-12 costs such as private school tuition.
However, there are some limits: You can only contribute $2,000 per year per child, and eligibility starts to phase out for couples earning more than $220,000 a year ($110,000 for singles). Funds not used by the time your child is 30 may be subject to taxes.
UGMA and UTMA Custodial Accounts
These types of accounts, where financial gifts to a minor are held in a custodial account until the child reaches adulthood, offer another option for saving for your child’s education.
They offer some tax benefits, but fewer than 529 plans. And unlike the other saving options, these types of accounts can also be considered your child’s asset, not yours — which means they can affect the amount of federal aid your child qualifies for when filling out the FAFSA.
One more thing to think about: The money belongs to your child, so at age 18 or 21, he or she can use it to pay for college as you imagined — or for something else entirely.
The bottom line
The best way you can currently save for your child’s future is to tuck money away in a 529 plan. If you are risk-averse and have a specific education institution you want your child to study at, you are probably better off opting for the Prepaid Tuition Plan. Alternatively, if you want a more flexible option, go for the Education Savings Plan. Either way, it’ best to begin saving for your child’s education as soon as possible.