What’s the Best Way to Save for College?

in Financial Planning by

If you follow the news, you’ve heard about the issues surrounding student loan debt. Recent reports from the New York Federal Reserve peg Americans’ outstanding student loan debt at $1.16 trillion, or an average of $33,000 per borrower.

Class of 2014 Graph

That is a massive number. With the cost of attending college continuing to rise and a growing student loan crisis on our hands it can be easy for parents to feel overwhelmed when it comes to saving for a child’s college education. This feeling is only compounded for parents of multiple children. Parents naturally want the best for their children and that often includes a college degree. However, they don’t want to see their children mortgage their financial future or jeopardize their own retirement to make that better life possible.

More Students Taking on Debt Graph

This dilemma leaves many parents wondering what is the best way to save for college. There are many factors to consider, including:

• Which savings vehicles to use
• When to start saving for college
• How to maximize tax benefits

Each family’s situation is going to be unique, but understanding a few basic principles can help you make a confident, well-informed decision that benefits both you as the parent and your child as the student. With that in mind, we’ve asked Matt Becker, a fee-only financial planner and founder of the Mom and Dad Money for some insight on how to best save for college.

When is the Best Time to Start Saving?

A common question parents ask is, “when is the right or ‘best’ time to start saving for college?” As with anything related to investing, more time is always better because it gives funds more time to grow. Starting right away may not be possible for parents who need to get their financial house in order. As strong as a parent’s desire to provide for his or her child’s future is, there are some basic things to have in place before beginning saving for college.

According to Becker, “I usually recommend that people wait to start saving for college until they have other priorities like an emergency fund, insurance and their own retirement savings on track.” This perspective of covering personal needs first might seem selfish, but providing for a child’s college education at the expense of your own financial well being could create a situation where you end up being a financial burden to your child in your post-retirement years.

After covering those pressing needs Becker mentions, you should then start thinking about saving for college. These options can start with as little or as much as you want – don’t allow the amount to hold you back. There are several college savings options that can benefit both you and your child as he or she starts contemplating where to attend college and for what purpose. You may have heard that the 529 Plan is the best way to start saving, but there are other options worth considering – depending on your means and needs.

What are the Best Options?

As a parent, you might think there is only one option to consider when it comes to saving for college. There are actually three options and two of those are excellent candidates to consider.

Option #1 – 529 Plans

The 529 Plan is likely the most well known option when it comes to saving for college. There are several features that make 529 Plans attractive. According to Becker, “529 plans have the fewest limitations when it comes to contributions. There are no income limits, meaning anyone can contribute.” This means that regardless of your income level, you can contribute funds to a 529 Plan. Not only that, but funds in a 529 work like those invested in a Roth IRA in that the growth is tax free and are tax free upon withdrawal, assuming they are used for qualified educational expenses. You are also not obligated to invest in a 529 from your own state, which adds greater flexibility.

The amount you can put into a 529 also makes them a solid option to consider. Federal tax law allows you to contribute up to $14,000 per year without incurring the federal gift tax. The beauty lies in the gift tax exclusion of a 529 Plan. The IRS allows you to contribute up to five years, or $70,000, total at once. While you may not be able to afford $70,000 at once, 529s do allow for contributions from other family members like grandparents.

In many, though not all, states they allow for a tax deduction on state income taxes for 529 Plans. The other thing to consider is that plans in some states offer only advisor-led investment options or no tax deductions. In an event like that, Becker adds that the low cost 529 Plans from Utah or Nevada are good options to look at when you’re not getting a tax deduction from your own state’s plan.

Option #2 – Coverdell Educational Savings Account (ESA)

Coverdell ESAs are another great option to consider if you’re interested in saving for college for your child. The Coverdell does not offer the heftiness in contribution limits that the 529 Plan does, but that should not cause you to discount them as an option.

The Coverdell ESA currently allows a contribution of $2,000 per year per child and growth acts just like that in a Roth in that they’re tax-free. The other nicety to Coverdell ESAs is they can be used not only for college, but also qualified K-12 expenses. If you live in a state that does not allow for an income tax deduction for 529 contributions, then a Coverdell can be a good option to consider.
The major drawback to Coverdells however comes in the fact that couples are not allowed to contribute to them if their modified adjusted gross income is over $220,000.

#3 – Custodial (UGMA/UTMA) Accounts

The final main option parents consider for their college savings needs are custodial accounts. Whereas both the 529 and Coverdell are full of benefits, the custodial account is lacking. One of the main drawbacks to consider, according to Becker, is the lack of tax benefits, not to mention harsher financial aid implications.

To make it worse, parents have significantly less control over the funds once the child hits age of majority, as the account becomes the property of the child. This makes the UGMA/UTMA really only beneficial if you simply want to provide your child a monetary gift or have already maxed out both 529 and Coverdell options.

Making Your College Saving Choice

While there are three main avenues to save for college, a rundown of them reveals that there are only two real options for most – the 529 and the Coverdell ESA. This point is even stronger when you consider that both of those options also allow for transferring of plans to other family members if the child they’re originally intended for does not end up attending college.

The question of which plan – the 529 or Coverdell is best for you, becomes a bit more complicated when taking a look at some of the intricacies offered by 529 Plans. In some cases, a 529 Plan may give you the ability to lock-in current tuition rates for future attendance tax-free, otherwise known as prepaid tuition through tuition credits. In many instances, these plans are administered by the individual states (though some schools do offer them directly) and are largely for public institutions, though Becker adds that some private institutions allow for prepaid plans. The other thing to consider is that in nearly every case you lose the ability to benefit from pre-payment if you move out of state.

Assuming you’re not going for prepaid tuition, then either the standard 529 Plan or Coverdell will both work similarly – contribution amounts notwithstanding. Either can be used for college education at public and private institutions. The Coverdell generally has more investment options as you can open them through an online broker, but most 529 Plans offer a wealth of index fund and age-based investment options. When owned by the parent, they both only count as 5.64 percent of your expected contribution as opposed to the typical 20 percent that assets of the child are in the event of them having a UGMA/UTMA account. This makes either the 529 or Coverdell justifiable options to look at, depending on your circumstances.

As With Investing, Cost is Key

Expenses are often overlooked when it comes to investing. Their importance is just as key when it comes to saving for college. According to Becker, “Some 529 plans have high costs associated with them, and that can be a reason to avoid them even if you would get a state income tax deduction for your contribution.” This necessitates taking a look under the hood when it comes to fees. Not every 529 Plan is created equally so expenses must be evaluated.

In some instances, states offer self-directed plans, but in others they are advisor led – which adds cost. On average, the difference between the two can be nearly .50 percent. While that seems insignificant on the surface, that difference will add up over the years. Like Becker said prior, in this event you would want to look at state plans like those offered in Nevada or Utah if your state does not offer a low-cost plan or if you do not receive a tax deduction.

Cost is one area that Coverdell ESAs can tend to stand out. Most online brokerages, as well as a handful of mutual fund companies, offer Coverdells as an account option. This can allow the freedom to choose an online broker that offers no-cost index funds to invest in so that you can keep your costs down.

Keep Your Eyes on the Prize

Saving for college can be overwhelming, but there are two great options to consider in a 529 Plan and Coverdell ESA. Both are distinct in the benefits they offer for both you as the parent from a tax perspective as well as for your child, to fund college. You can also use both plans concurrently, as long as you stay within annual gift tax limits.

It’s also important to remember that there are many ways to help fund a college education – loans, scholarships, grants and more – the key is to formulate a plan that makes the most sense for you and your child so both of you are set up for success, is which the ultimate goal of all your saving efforts.

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John Schmoll

John Schmoll is the founder of Frugal Rules, a blog created to help people experience financial freedom through frugality. John is passionate about budgeting, saving and investing and enjoys sharing his knowledge and experience with others so they can avoid making some of the mistakes that he made. A veteran of the financial services industry, John has an MBA in Finance and experience as a licensed stockbroker. You can follow him on Twitter at @FrugalRules

8 comments

  1. John

    What about using a Roth IRA? My wife and I both have pensions, 2 traditional IRAs and outside investments so our retirement investing look good. My father-in-law wanted to give them money for college so he had us set up a Roth IRA in my wife’s name. We used an Roth IRA because educational expenses are withdrawn tax fee (up to what you put in) and we didn’t like the fact that the money had to be used for education by your child or another child or that the child had control when they turned 18.

    Reply
    • Anonymous

      John, you would expect they included your idea(and mine as well) but no.

      Reply
    • Anonymous

      Very disappointing that this article does not mention the Roth IRA option, which is incredibly powerful. While 529 ties up the funds for educational expenses in perpetuity, the Roth IRA funds eventually become useful for other purposes.

      Reply
      • Tom

        So there’s drawbacks to the Roth option. You can’t withdraw profits tax free, just contributions, so it’s a bit like investing funds at zero percent for however many years. Also you can only contribute $5000 total across all of your IRA accounts, so you’re saving for college at the expense of your retirement.
        If you have leftover money in a 529 and have to pay taxes… That means you made money! More than enough to pay for college for your children! I’d say things probably went pretty well for you and your family.

        Reply
  2. Dave

    When my kids are finished college and I still have money left over in their 529 accounts (hopefully), am I correct in my understanding that I can treat this account as a form of retirement savings? If so, can they get rolled over into a traditional 401(k) or do they stay in the 529 plan? Also, assuming I don’t use the money for my own late-in-life education expenses, what restrictions (e.g. age) are there in using this money to fund my retirement?

    Thanks!

    Reply
  3. Tara Jones

    I like the idea of a 529 plan because my kids will be able to earn money for college as well and donate a portion of whatever they make straight to their college fund. I think it’s important for them to learn the value of saving up for future events, and I’m trying help them to set goals so they will have enough money when they turn 18. My oldest is even trying to find a little job so she can specifically raise a certain amount of money to donate to her funds.

    Reply
  4. Joan

    Great post. I believe setting goals helps one to be in control of their lives, this way you can work hard without any pressure and succeed.

    Reply
  5. Instant Essay Writing

    Your each Information is exceptionally helpful and great . Your article is extremely productive for comprehension. Thanks

    Reply

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