Best Ways to Save for College, Pt. 2: 529 Plan vs. Prepaid vs. Coverdell

Trying to figure out the best way to save? There are many factors to consider, such as the tax treatment of the invested funds, how the funds are considered for Federal Student Aid, and who retains control of how that money is spent.

But don't worry! In part 2 of this 5-part series, we will clarify these different types of accounts. We will explain the pros and cons of using 529 College Savings Plan, Prepaid plans, Coverdell or Educational Savings Account.

529 College Savings Plan

Most flexible & advantageous for higher education

A 529 college savings plan resembles a retirement account, but is designed specifically to save for college. It provides tax-free growth and tax-free withdrawals for qualified educational expenses beyond just tuition. While funds pulled out for anything other than qualified educational expenses are subject to a 10% penalty, the funds can be transferred to other beneficiaries, and used for any recognized college in the nation, and some foreign schools as well.

Pros

  • Tax Benefits: Tax-free growth and tax-free withdrawals
  • Flexibility: You can invest in any state’s plan and use at any recognized college. No age or income limits and very high savings cap
  • Broad Qualified Expenses: This money can be used for much more than just tuition, with room-and-board, books and technology all being legitimate uses of the funds.
  • Minimal Impact on Financial Aid: Considered assets of the parent, which reduces the impact on the amount of Federal Aid granted.
  • Retain Control: The parent retains control of the account to ensure that the money is spent where is should be.

Cons

  • Investment Options: You can only invest in the fund options offered by that specific plan.
  • Penalty: There is a 10% penalty for funds not spent on qualified educational expenses.

Prepaid Plans

Best for in-state public school, in selected states

Prepaid tuition plans look outstanding at first glance. Like the 529 College Savings Plan, they are outlined under section 529 of the Internal Revenue Code and share many of the benefits, including being free from Federal Income Taxes. With a prepaid tuition plan, you essentially pay for college tuition credits at today’s prices and your child may attend an in-state public school when the time comes. With the price of college rising so quickly, this can be an attractive option.

While locking in today’s tuition rate can be great, you do give up quite a bit of flexibility and you might have trouble accessing them in the first place. Few states continue to offer these plans, with many shutting down their programs in recent years. If you happen to live in one of the 11 states that offers them, you limit your child to the colleges included in the plan, typically the in-state public colleges, or risk being underfunded.

Pros

  • Locked-in Tuition Rate: Since you are buying in at today’s tuition rate, you don’t have to rely on market returns to pay for college tuition. This removes the worry that your money and investments won’t grow as fast as the rising cost of tuition.
  • Guarantee: Some (but not all) of the state plans offer a guarantee from default. With these plans, even if the state manages the fund poorly and gets into financial trouble, your tuition being paid is backed by the full faith and credit of the state.

Cons

  • Lack of Flexibility: The plan typically only pays for in-state, public colleges. If your child is accepted to a prestigious school in a neighboring state, or if you move, then you may be out of luck. Typically the plan will pay you the average cost of in-state tuition towards the other school.
  • Limited Costs Covered: The prepaid tuition plan is designed to pay for undergraduate tuition only. For many of these plans, room-and-board, books and other expenses will not be covered.
  • Lack of Access: Only 11 states offer these plans, and you must be a resident to participate.

Coverdell

Great for K-12, but restricted contribution limits

A Coverdell Education Savings Account is a common account used for educational savings as well. It shares many of the benefits of the 529 plan, with the expanded option of paying for K-12 school expenses as well. For families planning to send their children to expensive private high schools, these accounts can come in handy. When the goal is to save for college, however, these accounts can be pretty limiting. College is expensive and the cost is only rising. Coverdell accounts have a limit that does not allow you to save aggressively within them. If you are late to the game on college savings, or would like to gradually increase savings as college approaches, this cap can really get in the way.

Pros

  • All Education: These funds can be withdrawn tax-free for K-12 expenses, as well as college expenses.
  • Investment Options: You can choose your own investment options, and do not have to rely on the fund offerings inside a plan.

Cons

  • Low Savings Cap: The savings within these accounts is limited just $2,000 per year. While you may not be at risk of going over that cap in your current savings, you limit yourself to expand savings in the future.
  • Age Limits: All contributions must be made by the child’s age 18 and all funds used by age 30.
  • Income Limits: Restrictions on who can utilize these plans, as there is a phase out on who can contribute to these plans for high-income earners.

While some unique situations may call for another savings vehicle, the 529 plan is a no-brainer for a family who wants to save for all of college’s expenses tax-efficiently, while minimizing the effect on federal financial aid, retaining control of the funds, and leaving open all types and locations of schools.

This stuff can be confusing and complicated, but opening your 529 plan and getting a jump start on saving for college doesn’t have to be! CollegeBacker is an SEC-registered investment adviser that makes the process as seamless and clear as possible. We'd love to help you navigate the complex world of college savings.

This is the second of a 5-part series comparing options to save for college.