In a NutshellWith the high costs of going to college, investing in a college savings plan can make a big difference in affordability. Here are seven different options to consider.
With the average cost of attending a four-year college ranging from $27,330 to $55,800 annually in 2021-22, according to the nonprofit CollegeBoard, a college education isn’t getting any cheaper.
College can be expensive, even if you spend years saving for it. Fortunately, there are many ways you can tackle college savings, some of which offer important tax advantages. Here’s what to know about seven different college savings plans.
- 529 plans
- Prepaid tuition plans
- Coverdell education savings accounts
- Roth IRAs
- Uniform Gift to Minors and Uniform Transfer to Minors
- Savings bonds
- High-yield savings accounts
1. 529 plans
This may be the first thing that comes to mind when you think about college savings plans. A 529 plan is a tax-advantaged savings plan. Your contributions grow tax-free, and withdrawals are tax-free if they’re made for qualified education expenses, which include up to $10,000 annually in K-12 tuition and fees.
You can contribute up to $16,000 ($32,000 per married couple) per person who will benefit in 2022 before you reach the annual gift tax exclusion. (That number is inclusive of any other gifts.)
While 529 plan contributions aren’t deductible on your federal tax return, many states offer residents tax credits or deductions on contributions made to their state-sponsored plan. If your state doesn’t offer tax benefits, you can shop around for a plan through another state or a private plan through a brokerage firm.
529 plans can only have one beneficiary, but if you have multiple children, you can typically switch beneficiaries subject to certain restrictions. Non-qualified withdrawals will be assessed federal income taxes and a 10% federal penalty, but if your child receives a scholarship, you can generally take an equal withdrawal from their 529 plan without incurring the penalty.
2. Prepaid tuition plans
A prepaid tuition plan is a type of 529 plan offered by certain states and educational institutions, though it’s not as widely used as the 529 college savings plan.
Investing in a prepaid tuition plan essentially lets you lock in the price of a future college education at today’s price point. You can either make a big one-time payment or a series of smaller monthly installments to purchase tuition amounts (in years or credits). You can then use those amounts to pay for future tuition (but not room and board) at an eligible college or university.
When your child is ready to go to college, the amount you’ve saved can be used toward your child’s education at a qualifying school.
This option may be worth considering if you’re concerned about the rate of tuition inflation. But keep in mind that it’s based on in-state public schools, so if you move to a different state or your child wants to attend a private university or an out-of-state school, they may need to seek additional ways to pay for college. If your child doesn’t attend college, you may be able to change the beneficiary.
3. Coverdell education savings accounts
A Coverdell education savings account, or ESA, allows you to save for your child’s college education on a tax-deferred basis. Withdrawals are tax-free if you use them strictly for qualified education expenses and the amount you take out doesn’t exceed the beneficiary’s yearly qualified education expenses. In addition to college costs, ESAs can also be used to pay for K-12 education expenses.
Contributions don’t qualify for tax deductions or credits. Also, if you take money out of the account for non-qualified expenses, you’ll be assessed federal income tax on a portion of the withdrawal plus a 10% penalty.
Unlike a 529 plan, there are some additional restrictions on a Coverdell ESA. For starters, you can only contribute up to $2,000 annually per beneficiary. And you can’t contribute at all if your modified adjusted gross income is $110,000 or more (or $220,000 if you’re married and filing jointly).
Finally, the beneficiary needs to be under the age of 18 or have special needs when you establish the account, and the account funds must be completely distributed by the time they reach age 30 unless they have special needs.
4. Roth IRAs
A Roth individual retirement account, or IRA, is primarily designed to help you save for retirement, but you can also use it as a college savings vehicle. Contributions made to a Roth IRA are made on an after-tax basis, similar to other college savings plans, and your contributions grow on a tax-free basis.
Traditionally, if you take money out of a Roth IRA before you reach age 59 1/2, you’ll have to pay income taxes on the earnings portion of your withdrawal, plus a 10% penalty. If you take the money out for qualified education-related expenses, you’ll still owe taxes on the earnings portion of the withdrawal, but there won’t be a 10% penalty. If you reach the age threshold by the time your child is in college, you won’t have to pay taxes on any of it.
That said, you can only contribute up to $6,000 annually to a Roth IRA ($7,000 if you’re age 50 or older), and there are income limits, including a phase-out period. Reference the IRS website for up-to-date information about income limits.
5. Uniform Gift to Minors and Uniform Transfers to Minors
Setting up a Uniform Gift to Minors Account (UGMA) or Uniform Transfers to Minors Account (UTMA) allows you to save for college without the threat of tax penalties if you withdraw money for non-educational purposes. Once your child reaches the age of majority in your state (the age they’re considered an adult), they’ll gain control of the account and can use the funds however they want.
However, these accounts come with some complications. First, you can contribute as much as you want, but the gift tax applies, so you’re limited to $16,000 (or $32,000 for a married couple) before you hit the annual gift tax exclusion.
Also, when you’re filling out the Free Application for Federal Student Aid (FAFSA), funds in an UGMA or UTMA account will be considered the child’s assets, and your child’s financial aid eligibility will be reduced by 20% of the value of the account.
Taxes on income earned from UGMA and UTMA accounts can get a little complicated, too, so consider consulting with a tax professional before you open one.
6. Savings bonds
Most college savings accounts provide an opportunity to invest your money, but with the potential for higher returns also comes greater risk. If you want a safer way to save, you may consider buying Series EE or Series I savings bonds.
If you use the bond proceeds to pay for qualified education expenses, you won’t have to include that income on your tax return, as long as the bond is issued to a parent or child who is 24 years of age or older and your income is below the threshold set by the IRS. Your filing status also can’t be married filing separately, you must have paid qualified education expenses for yourself, your spouse or dependents in the same tax year and you must have cashed the savings bond the same year that you claim the exemption.
Additionally, Series I bonds charge a penalty to the tune of three months’ interest if you cash in your bond within five years of buying it.
7. High-yield savings accounts
Another low-risk alternative to other college savings plans is to put your money in a high-yield savings account. While the interest rates on these accounts can fluctuate over time, they tend to be higher than what you’d get with a traditional savings account.
That said, it generally isn’t high enough to beat inflation, and you won’t get any of the tax benefits that you might qualify for with other college savings methods.
This option may be worth considering if your child is older and you don’t have enough time to generate higher earnings with an investment-focused college savings plan, or you simply don’t want to be tied to using the money for college.
Next steps: What should I consider when researching a college savings plan?
There’s no single college savings approach that’s guaranteed to work best for everyone, so it’s important to ask yourself some questions about your situation and goals.
For starters, it’s best to try to begin saving for college as early as possible, even if you can’t set a lot of money aside yet. With that in mind, compare the different options you have and see which one will give you the best tax benefits, such as deductions or credits for contributions and tax-free growth and withdrawals.
You’ll also want to look at the potential rate of return and how that compares to the potential risk of the account. If you have a long time before your child enters college, you may be able to take on more risk with an account that allows you to invest in stocks, mutual funds and exchange-traded funds. But if your child is starting college in the next few years, you may want a safer option.
Finally, think about your other financial goals and about how an education savings plan fits in. If you’re having a hard time saving for retirement, for instance, you may want to put education savings on the back burner for now. The same goes for other important goals, including buying a home, obtaining enough insurance and more.
While saving for college is important, it can spell financial trouble for you down the road if you neglect your own financial needs.