With the average 2017 college graduate having $39,000+ in student loans and the cost of college steadily increasing, parents cannot begin saving too soon for the college education of their children. As tuition costs continue to increase faster than inflation, simply saving for college with traditional savings accounts isn’t the best college savings option for many families. Instead, parents should consider a tax-advantage account that will increase in value simultaneously. Plus, the student or parent will (hopefully) not have a mountain of debt once they receive their diploma.
Below are a couple of different options to save for college. One or more options might be applicable to your situation.
529 College Savings Option
When the phrase “college savings option” is mentioned, the numbers 5-2-9 are probably the first thought to pop into many parents’ heads when planning for college. These savings accounts were first created in 1996. They allow parents to help their children squirrel away money for college without a tax bill.
529 accounts are funded with contributions. The earnings grow tax-free if the withdrawals are used for qualified college expenses such as tuition and fees, books, room and board, or other fees required to attend college. When applying for financial aid, the 529 plans are considered a parent’s asset. They will not penalize the child and their financial needs.
Investment Strategies With an 529 Fund
529 funds offer several different investments strategies. One option can be in individual investment funds. The other is investing with an age-based strategy that gradually shifts from more aggressive to more conservative investments as the withdrawal date approaches. The age-based investment strategy allows contributions to invest in riskier options when the child is still a newborn.
They have a better probability of producing higher yields than funds recommended for an 18-year-old high school senior that cannot afford for the savings plan to sharply drop in value two weeks before tuition is due. In other words, the parents of a 10-year old shouldn’t invest in an age-based portfolio intended for a toddler. The additional risk is not worth the potential reward.
How Much Do 529 College Plans Cost?
Most 529 plans do not charge any type of setup or maintenance fee but this can vary. As the contributions are invested in mutual funds, there might be a small operating fee to cover the trading and administrative functions. These same fees are charged to mutual funds also held in taxable brokerage accounts, 401Ks, and IRAs.
There are a couple different variations of 529 plans available. Most states offer their own college savings option. However, sometimes residents can join other state’s plans, even if their child will not attend a college in that state. For example, a Tennessee resident can invest in the Alaska 529 plan even if the child attends a college in Texas. If you are not pleased with the investment offerings or fees of your local state (or your state doesn’t offer a 529 plan), this is something to keep in mind. Just be sure that this is an option.
Some states also offer prepaid tuition plans. These plans are more restricting regarding eligibility and redemption rules. This is a good option if you are certain your child will be attending an in-state school. As nobody predicts college tuition to cease increasing significantly year-over-year, this is a good plan to consider. You can prepay $5,000 today for what might cost $10,000 in the future when your child finally attends college.
What If My Child Doesn’t Go To College?
The largest fear among parents with 529 plans is that their child does not attend college. It’s essentially like buying a car for their 16th birthday and they do not have a driver’s license. Thankfully, many 529 plans allow parents to transfer funds to other beneficiaries that will be attending college.
Unlike IRAs or 401Ks that have mandatory withdrawal dates, 529s can remain untouched for several years in case the child returns to college in the future. If college is nowhere on the radar, funds can also be withdrawn for a penalty. The penalties and transfer policies differ among the plans, so it pays to research the fine print.
Coverdell Education Savings Accounts
Originally called an Education IRA due to their investment flexibility, these savings accounts work similar to 529 savings plans but have stricter contribution limits and custodian rules. Education savings accounts are self-directed (unlike a 529 or 401k). This means the parent can invest in whatever stock or mutual fund they want to, not just the 13 or so choices that a state 529 or employer 401k plan offer.
Annual contributions are capped to $2,000 per child if parents make below $95,000 to $110,000 for single taxpayers and $190,000 to $220,000 for married taxpayers (similar to IRA contribution limits). Coverdell accounts are also federal tax-exempt. However, they are more subject to state income taxes than 529s.
These savings accounts (like 529s) also count the funds as the parents’ asset instead of the student’s asset, which can help with during the financial aid process. These types of savings accounts can also be used for K-12 education expenses, which can be helpful if the additional funds will not be needed for college.
A parent can withdraw funds that are not put to use for educational purposes for a penalty. Most plans also allow funds to “rollover” into a 529 account. Whether the child attends college or not, all contributions are irrevocable and belong to the child when they reach adulthood.
UGMA and UGTA Custodial Accounts
These two accounts are probably the worst option for dedicated savings accounts. They have the fewest tax deductions and the money belongs to the child when they reach the age of 18 or 21 (depending on when the plan determines the custodian account to terminate). They can spend the money for college or for anything else.
These accounts also consider all assets to be for the child. This can negatively impact applying and qualifying for additional financial aid when completing the FAFSA. One positive is that non-education withdrawals are not subject to the same penalties as 529 or Coverdell education savings accounts.
Many people think that Roth IRAs are a tax-advantaged way to save for retirement. They are. But, one of the loopholes is the ability to withdraw contributions tax- and penalty-free for qualified educational expenses. The Roth IRA should have a history of at least five years. Additionally, the contribution limits are contingent to annual taxable income when funding the IRA.
You probably won’t be able to cover all the college expenses. However, this can also be a good hedge in case a child does not attend college. The funds can still be used for the original intent of being saved in a tax-advantaged retirement account. This unconventional “savings account” is a good secondary option to supplement a 529 or Coverdell account. It can also be a way for parents to contribute if their child is ready to attend college and participate in a college savings option.
Another “perk” saving with a ROTH IRA is that it is a better option because of tax savings and more lenient contribution limits. A ROTH IRA is self-directed. This allows parents to invest in stocks and funds that can pay higher yields than the options offered by a state 529 plan.
A final recommendation is also teaming up with Upromise that offers free college savings options and cash rewards for purchases through the Upromise shopping portal. These can be deposited into a Upromise GoalSaver savings account or 529 plan. The GoalSaver savings plan has a 10% match on all cash back rewards earned through the Upromise shopping portal (Upromise Rewards Account).
To qualify for the 10% bonus, the parent must maintain a minimum balance of $5,000. In addition to the match, Upromise also pays an annual $10 anniversary bonus. Additionally, they pay a $100 bonus on the third anniversary if the minimum deposit is maintained.
What College Savings Option Is The Best?
Every family will have different financial needs when it comes time to paying for college. The best and easiest college savings option is the 529 accounts because of the high contribution limits and the tax breaks. If a family has multiple children, it is likely that at least one child will attend college. Those funds can still be set up for use.
Just as investors recommend diversification, it’s not a bad idea to invest in two or three of the accounts mentioned above. Parents should definitely consider putting a certain portion of savings into a ROTH IRA that allows parents to self-direct investments. It is similar to a Coverdell account. However, the money is still the parents’ if the child does not go to college.
Signing up for a Upromise account is a good college savings option as well. It pays better than a traditional savings account. It has protections from stock market swings. Plus parents can earn Upromise rewards.
No matter how you save for college, it is never too early to start. Just like retirement, it pays to “save early and save often” as it will arrive sooner rather than later. Consider a college savings option to help.