So, you’ve decided to start saving for your child’s college. Great! Maybe you’ve paid off your own student loans and you want to save your kids from the same fate. Or maybe the grandparents keep hinting that it’s time to get started. Or you simply want to do the right thing for your kid.
But you’re overwhelmed with options. Should you save in your own savings or investment accounts? An old-fashioned Series EE Savings Bond or CD? And then, you start hearing about 529 College Savings Plans, Coverdell Educational Savings Accounts, and even retirement accounts like Roth IRAs and 401ks. When you run into UGMA/UTMAs, it feels like you’ve gone too far…
Today, we will be your guide. After analyzing all the options, we show you the best way to save for college. We use three simple criteria that matter for every family: Growth, Financial Aid, and Flexibility. Finally, we tell you about the one winner that is an incredible, powerful tool to save for college. (Skip to Chapter 4 if you can’t wait!)
Table of Contents
- Growth: Time is Your Best Friend
- Financial Aid: How to Maximize Your Free Money
- Flexibility: What Can I Spend On? What About Emergencies?
- And The Winner Is… 529 Plans
- Exceptions: Is a 529 Always The Right Answer?
- Glossary: What You Need to Know About Each Account Type
Growth: Time is Your Best Friend
If you’re saving for a young child, you already have one huge advantage: Time.
But it’s only an advantage if you make some smart choices about growth. A tax-advantaged investment account maximizes your growth potential. In comparison, other accounts are simply hobbling along – or even standing still.
Which accounts are standing still? Savings accounts typically earn less than 1% interest. CDs and savings bonds are not much better. When you save with these accounts, you’re doing all the work. Considering the rising cost of college, you might even be losing ground.
Taxable investment accounts are better, gaining momentum as they grow every year. You do some of the work, diligently saving month after month, but then your hard work is multiplied as the money grows.
But if you really want to speed ahead, choose a tax-advantaged investment account. Normally, taxes on your investment gains will reduce your savings, but these special accounts have tax benefits that will accelerates growth even further.
You could more than double your money in 18 years – if you choose the right way to save.
That’s why - if you’re concerned about maximizing growth - you need to leave behind those deadbeats like savings accounts and CDs. Even most investment accounts are leaving money on the table. Instead, focus on tax-advantaged investment accounts.
Financial Aid: How to Maximize Your Free Money
When saving for college, it’s critical to remember that we also want to minimize the impact of our saving on financial aid. After all, we want as much free money as possible! In this section, we’ll address why retirement accounts, student savings, and trusts might not be such a great idea.
Financial aid calculations are tricky, and there’s a lot of misinformation out there, so it pays to be careful. For example, you may have heard that you should save for college in a retirement account, because those balances are invisible in financial aid calculations BUT this is only part of the story.
Using a retirement account to pay for college can hurt financial aid.
How? Withdrawals from a Roth IRA or 401k may be counted as income for the following year’s financial aid. Unlike retirement assets, income is not invisible. In fact, income has a massive impact on financial aid eligibility, with up to 50% of student income and 22-47% of parental income contributing to expected family contribution (learn more).
So yes, it is true that using a retirement account will not affect your first year’s financial aid eligibility, and it is also true that there are education exceptions for early withdrawal penalties (though you still have to pay taxes). However, once you consider the multi-year college journey, using a retirement account is not a good idea.
Similarly, savings accounts in the child’s name or custodial accounts like UGMA/UTMA can have a very negative impact. About 20% of student assets are added to your expected family contribution.
So what will actually minimize impact on financial aid?
Use an account specifically designed for education. With a 529 plan, Prepaid Plan, or Coverdell, withdrawals are not counted as income and your savings are considered parental assets. Only up to 5.64% of parental assets contribute to expected family contribution.
Flexibility: What Can I Spend On? What About Emergencies?
In this section, we’ll evaluate the remaining accounts based on three types of flexibility: flexibility of school choice, of contribution amounts, and in case of emergencies.
We wrote this article assuming that you’re saving for college. But which college? If you want to give your child the freedom to choose a school other than an in-state public school, avoid the Prepaid plans. Though these are typically great deals, they are designed to be used at in-state public schools and you might be left with less savings than you’d hoped for if your child chooses a different school.
You also probably want to be able to save as much as you can. Coverdells have a maximum contribution limit of $2000, and there are also income limits regarding who is allowed to contribute. If you might exceed those limits, you may want to avoid a Coverdell.
This leaves us with a 529 plan, but you might be wondering about one more question: What about emergencies?
No problem. With a 529, you can always withdraw the principal (i.e., your original contribution) without any taxes or penalties. You contribute post-tax dollars, and then you enjoy tax-free growth and tax-free withdrawals for higher education. There are withdrawal rules, of course, but these only apply to the investment gains - so again, you can always withdraw the principal without taxes or penalties.
529 plans are impressively flexible – emergency withdrawals, a variety of school choices and expense categories, and even gift contributions from family & friends.
529 plans are flexible in other ways too. You can choose any higher education institution that qualifies for federal financial student aid - which includes in-state and out-of-state, public and private, undergraduate and graduate, and even many trade schools and institutions abroad. You can also spend it on much more than tuition, such as room & board, books, and computers.
And there are no annual contribution limits or income limits. You cannot contribute beyond the maximum aggregate balance (~$300,000, depending on the plan), but if you want to save more, you can simply open another plan.
Lastly, you can even get family and friends involved. Even though a 529 plan has a single account owner, anyone can contribute directly into a 529 - which means birthday parties, holidays, and other milestones can be opportunities to boost your college savings.
And The Winner Is… 529 Plans
Whew! That was a lot of information to digest. We’ve finally landed on a winner for most families - a 529 College Savings Plan - but we haven’t even properly introduced it!
A 529 College Savings Plan is a tax-advantaged investment account that helps you save for college. You contribute post-tax dollars, and then your money grows tax-free and can be withdrawn tax-free for higher education. A 529 plan also minimizes impact on financial aid, and it’s surprisingly flexible for different types of schools, qualifying higher education expenses, and even emergency withdrawals.
In other words, a 529 Plan is a great choice for most families – offering impressive growth potential, minimal financial aid impact, and surprising flexibility.
We hope this has been an informative and approachable way to learn about the best way to save for college. At CollegeBacker, we can help you navigate this process even further and rally family & friends to help. It only takes a few minutes to start saving for your own family, or send a gift to kickstart college savings for another family - and it’s free to start. Or, if you have more questions, ask us at firstname.lastname@example.org.
Exceptions: Is a 529 Always The Right Answer?
Not quite satisfied? We understand. One size does not fit all when it comes to college planning. While a 529 plan is incredible for many families, there are three major exceptions to this rule:
1. You know you’re shooting for in-state public.
Check if your state offers a Prepaid Tuition Plan. Only 11 states do, but if you’re a resident and confident that your child will attend, these can be a phenomenal deal. 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.
2. You also want to spend the money on K-12 education (e.g., private school).
Consider a Coverdell. These accounts can also be used for qualified K-12 expenses, such as a private elementary, middle, or high school. A few rules to keep in mind: Maximum contribution of $2000 per year, all contributions must be made by the child’s age 18, and all funds used by age 30. Income limits also apply.
3. You are likely to need the money for something else.
Remember, if you’re only concerned about a small, unexpected emergency, a 529 plan may still be a good option since you can withdraw the principal without taxes or penalties, for any purpose. However, if you’re likely to need the money for a car, retirement, or another non-higher education expense, you probably should choose a different account.
Glossary: What You Need to Know About Each Account Type
- 529 Plans: Most advantageous account for higher education, 529s are a tax-advantaged investment account with significant flexibility
- 529 Prepaid Plans: Best for in-state public school, Prepaid Tuition Plans are only available in selected states.
- Coverdell: Great for K-12, this tax-advantaged investment account is limited by restrictive contribution limits, income limits, and other rules
- 401k: This employer-sponsored, pre-tax retirement accounts triggers taxes and impacts financial aid if used for higher education, although there is a education exemption for the penalty.
- Roth IRA: An individual, post-tax retirement account. Like 401ks, they trigger taxes and impact financial aid if used for higher education, but there is no penalty incurred.
Custodial Accounts / Trusts
- UGMA/UTMA: These taxable custodial accounts are automatically controlled by the child at age 18 or 21, cannot be transferred to anyone else, and will hurt financial aid.
- Crummey Trust: Similar to the UGMA/UTMA, except that you can specify a later termination date beyond age 18 or 21.
Other Ways to Save
- Savings / Checking Accounts: With minimal growth potential, these accounts are better used for day-to-day finances than long-term savings for college.
- Taxable Investments: Great for a savvy investor to personally manage investments, but lacks the tax benefits of other accounts.
- Certificate of Deposit (CD): FDIC-insured investments with low interest rates (~2%), CDs are unlikely to keep up with the rising cost of college
- Savings Bonds: Backed by the full faith & credit of the US government, savings bonds typically pay very little in interest.