Ah, college. If you’re a student, it’s a time of new beginnings and the promise of the future. For whomever’s paying, it’s the reality of a stack of big fat bills. How do you pay for college without checking into the poor house?
I bring good news: you have several options. Let’s explore.
Why Many College Savings Options Don’t Work
While overall inflation rises at around a three percent rate, college costs have shot up annually anywhere from 4 to 10 percent. Families struggle to plan when they aren’t sure how much costs will rise by in any given year. In my financial planning practice, we counted on seven percent per year inflation rate when calculating savings needs. That’s toward the high side of the range shown above, but conservative planning helped to ensure we’d covered the worst case scenario.
Why do we need this data when picking investments? If you invest in CDs or low-paying savings bonds for college, you’re actually losing purchasing power on the value of your college investment. Just as there are top states to live in based on taxes and lifestyle, there are best college savings options based on financial aid and tax ramifications.
A List Of College Savings Plans And Investment Options
While savings bonds, CDs and savings accounts are suboptimal investments for college savings, wise families still have plenty to choose from. Here are five popular choices:
1) 529 Plans
State-sponsored 529 plans combine tax benefits and a wide variety of investment options. Money saved into a 529 plan grows tax deferred and, if used for college, can be removed tax free. Additionally attractive, 529 plans don’t have to be owned by the person attending college, lowering this investment’s toll on expected family contribution—the number most schools glean from the FAFSA form to determine financial aid.
Parents who set up 529 plans have a range of options. Many states have both advisor-assisted accounts and individual accounts (advisor led funds usually have sales charges attached which cover the advisor’s commission). While many states offer plans which grow state-tax free, if your state’s 529 plan is a non-performer you can waive this privilege and instead use another state’s plan. As an example, the Alaska 529 plan offered by T.Rowe Price and the Colorado plan offered by Vanguard and UPromise are two low-fee options open to investors outside of the state. Thinking about opening an account? Compare your state’s available plans to those offered through other states, before heading to your state’s plan page to open an account.
Our favorite upsides: Many account and investment options and the opportunity for low fees and passive, index-style management.
Watch out for: You can move the money to another beneficiary if the original student decides not to attend college, but there’s a hefty penalty to remove any money your account earned if you need the money to pay bills. You’ll incur a 10 percent penalty on earnings, pay ordinary Federal income tax and applicable state taxes if you received a tax break on your contributions. Ouch.
2) Coverdell ESAs
In 2002 Congress renamed the low-contribution Education IRA the Coverdell Education Savings Account and raised the contribution limit to $2,000 per year per individual donor–including the beneficiary–as long as your modified adjusted gross income does’t exceed $110,000 if you file single or $220,000 if you file a joint return.
A Coverdell ESA enjoys tax benefits similar to a Roth IRA. Money grows tax deferred and may be removed tax free for qualifying expenses. Specifically, Coverdell ESAs may be used for private K-12 education expenses or qualifying college expenses (tuition, book, room and board). Most traditional mutual funds, exchange traded funds, stocks, bonds or CDs may be used inside of a Coverdell ESA.
Our favorite upside: If you have kids headed to private K-12 schools and want to sock some money away for the future, this is your account. Also, there are nearly unlimited investment options.
Watch out for: If you let a commission-paid advisor choose your funds, you could pay huge fees for your investments. Also, because 529 plans allow much larger contributions, they often overshadow Coverdell plans as a college savings vehicle.
3) Non-Qualified Accounts
Some people stuff college money into a regular brokerage account at a bank or fund company. Saving this way gives you supreme flexibility. There are no rules to remember or potential pitfalls directly associated with the account, unless you save into an account in the student’s name. Money saved in the students name (if the recipient is under age 18 it’s called an UTMA or UGMA account, depending on where you live) cannot be removed later by a parent for expenses unrelated to the child, including basic food, clothing or shelter expenses.
The biggest upside: Flexibility. You can use this money for any other expense you wish unless you are saving in the name of a minor using an UTMA or UGMA account.
Watch out for: Taxes and financial aid. You won’t shelter your savings from taxes at all using this method. If you start saving while the future college entrant is young, that could add up to a ton of taxes.
Money saved into a non-qualified account shows up most poorly for financial aid purposes. If the money is saved in the student’s name, every dollar will count toward the FAFSA expected family contribution formula. If saved in a parent’s name the EFC doesn’t look much better; parents are allowed a small amount as an emergency fund then all this money counts against the family’s expected family contribution.
4) Roth IRAs
While many people don’t think of Roth IRAs as a college savings vehicle, they’re flexible enough that they just might work. Money inside a Roth IRA may be used for qualified education expenses without the normal 10 percent early withdrawal penalty. You’ll still pay taxes on an income your gains generated and room and board are only considered qualified expenses if it’s spent for at least half time college attendance. Like other investment accounts, you’ll choose from a nearly limitless array of investments inside of a Roth IRA.
The biggest upside: One less account. Who can keep track of several different funds? By lumping the money into your Roth IRA, you’re eliminating complexity.
Watch out for: Your Roth IRA is best used alongside pre-tax plans as part of your overall retirement strategy. If you’re trying to control your retirement tax bracket, using your Roth IRA for education expenses diminishes your flexibility later.
5) Insurance Policies
I know what you’re thinking, and so am I.… If an insurance agent tries to sell you on using a permanent life insurance policy with cash value to pay for college, you should probably run the other way. However, there are a couple of ways where insurance is an attractive option.
Money inside of an insurance policy doesn’t count toward the FAFSA expected family contribution calculation, so this option gives you the biggest boost toward financial aid consideration. Also, if the insurance is in the name of a parent that’s going to pay for college, the death benefit can be used for tuition if the parent passes away before the student matriculates. Some policies have cash values that grow in mutual fund-like accounts, so returns can be competitive.
The biggest upside: If you’re sure you’re going to be a candidate for financial aid, this is the best option.
Watch out for: Everything else. Most permanent life policies are confusing, laden with fees and underperform similar investments outside of insurance products. Unless you know you’re a strong candidate for financial aid, steer clear of this option.
Throwing a few dollars into a 529 plan and hoping for the best isn’t a college plan. The process of choosing the right investment for you should be more comprehensive than looking at your state-sponsored accounts. While signing up for a state-sponsored 529 plan may be the right move for the majority of savers, a Coverdell ESA, non-qualified plan, Roth IRA or insurance policy might meet your individual needs better. Start with your goal and work backward, and you’re more likely to find the perfect college savings tool.
A Note About FASFA
While you might be thinking, “I don’t qualify for financial aid, so I’m not worried about the FAFSA,” this form should play a role in your decision making. The FAFSA form isn’t just for low income families who are likely to get financial aid. Anyone hoping to use low-cost student loans for college will need to fill out a FAFSA form. Regardless of your income stream, if you’re enrolled at least half-time in a school that participates in the Direct Loan Program (this is most schools in the United States), you’re eligible for an unsubsidized Stafford loan, and maybe more. The FAFSA is the gateway to a host of grants (such as the Pell Grant) and loans. Your school will often require you to fill out the FAFSA form if you want to apply for any aid.
There are many factors at work in the FAFSA which determine your aid eligibility. While your income (and family income, if you’re a dependent) is one driving force, the form also takes into account the cost of the school you’re attending, your year in school and your enrollment status. That’s why it’s important to lower your expected family contribution; if you’re on the fence for financial aid at your college, how you save money could be the difference between receiving aid and paying out-of-pocket for your entire college experience.
It’s scary to think how much college tuition will cost for parents with newborns. The chart above by Baird is probably conservative. It’s vital parents plan early and save aggressively. And if worse comes to worse, let’s hope that all we need to learn will be for free online. Free online BA degree in economics from Harvard anyone?
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