Putting away enough money to pay for college costs can seem daunting, but there are several ways to do it, each with its own advantages.
There are two kinds of 529 plans, which are named after a section of the U.S. Tax Code:
- With a 529 prepaid tuition plan, your contributions essentially buy tuition credits that can be used later at specific colleges or universities. If the student goes to a school that’s not covered in the plan, the money may be used at another school, or a sibling may use the money at one of the covered colleges or universities.
- With a 529 college savings account, your money can be used for any qualified higher education expense at a qualified higher educational institution.
With either type of account, your contributions are not tax deductible, but earnings grow tax free as long as you use any withdrawals for qualified education spending. Parents must report savings in a 529 account that they own as part of their assets when applying for financial aid, but accounts owned by grandparents, other relatives or friends need not be reported (but can still be used to help pay for your child’s education).
The benefits of 529 plans include:
- There are no income limits and there are lifetime contribution limits of over $300,000 on most plans.
- There may be state tax advantages for plans sponsored by your state. Since each plan’s investment options and record are also important, compare the value of any state tax advantage against the strength of the investment choices a state plan offers.
- Grandparents and others who contribute to a plan can deposit as much as $14,000 each (in 2017) without the gift being taxable. They can also each make a total contribution of up to $70,000 in one year, and the total will count against five years of gift contributions.
- It’s possible to change the plan beneficiary if, say, one child decides not to attend college.
529 plan drawbacks to consider include:
- Plan fees and expenses will be deducted from your balance.
- Withdrawals of earnings are taxable and subject to a 10% penalty if not used for qualified educational expenses.
- There may be limited investment choices, and none at all with prepaid tuition plans.
- There’s no guaranteed return and you could lose money on your investments, depending on the type of plan and investment you pick.
- There are generally limits on how often you can change investment choices or plans.
- Prepaid plans may not cover all funding needs if the student chooses to attend a private college or one that’s out of state. There also may be time limits on when the tuition credits in a prepaid plan may be used.
U.S. Savings Bonds
U.S. EE and I savings bonds have long been considered a safe and reliable way to save for the future, including for a child’s education. Some of their pros include:
- They can be purchased for as low as $25 face value and as high as $10,000.
- They earn interest for up to 30 years.
- They are exempt from state and local taxes, but interest earned is subject to federal and estate taxes. Interest on EE and I bonds may be exempt from federal taxes in some circumstances (and based on income limits) if the money is spent on qualified higher education expenses.
- You may be able to get a better return on other investments, such as mutual funds, direct purchases of stocks and bonds or investment plans available through a 529 plan. (You can also lose money with these alternate options, however, which would not be the case with a U.S. savings bond.)
- Their interest is not necessarily exempt from federal income tax.
Coverdell Education Savings Accounts
This tax-advantaged option has some important differences from and similarities to 529 plans. In both cases, earnings can grow tax free if used for qualified educational expenses. There are also taxes and penalties for withdrawals of earnings that are not used for education. Some differences between a Coverdell and a 529 include:
- You can only contribute $2,000 annually to a Coverdell.
- There are income limits for Coverdells, but none for 529s.
- While rules for 529s vary by state, contributions aren’t allowed to Coverdells for beneficiaries over 18 and a beneficiary can’t be over 30 (unless, in both cases, the beneficiary has special needs).
- Coverdells can be used for elementary and secondary school expenses, while 529s cannot.
- You can choose virtually any investment for a Coverdell, but 529 accounts are limited to those offered by plan sponsors.
Two types of savings account do not have tax advantages but they do offer other benefits that college savers may want to consider. They are referred to by the acronyms for the legislation that established them: UTMAs (the Uniform Transfers to Minors Act) and UGMAs (Uniform Gifts to Minors Act). Features of these accounts include:
- A custodian, which can be a parent or someone else, manages the money while the child is a minor.
- A portion of the account’s investment earnings is taxable to the child, usually at the parent’s tax rate.
- The money can be used for any purpose, not just education.
- The investment choices are unlimited.
Trusts are another generally more expensive option for setting aside money for minor children. Choices include irrevocable trusts and 2503 trusts.
The Bottom Line: Start Early
The longer your money is tucked away in a college savings or investment account, the more time it has to grow through regular additional deposits, as well as interest and dividends earned. Make saving for college a habit, something that you include on your monthly budget. Even a small amount weekly will add up over time. The sooner you begin, the easier it will be to end up with more money later.
Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits