Many or all of the products featured here are from our partners who compensate us. This may influence which products we write about and where and how the product appears on a page. However, this does not influence our evaluations. Our opinions are our own.
College seems a long way off when you bring your new baby home from the hospital, but the far-off nature of higher education shouldn’t move college savings strategies too far down your list of priorities. The good news is that there are several methods that can help you get started saving now, potentially saving your child (and you) from student loan debt down the road. More good news: We’re helping you choose the right approach for your family by outlining how the following options work:
Coverdell Education Savings Accounts
CDs and savings bonds
There are precious few hours in the day when you’re a new parent. But when it comes to establishing a college fund for your newborn, time is actually on your side for once.
Building a college fund can be a major financial challenge. The College Board reports the average annual cost of tuition and fees can range from just over $9,000 annually for in-state residents at public universities to more than $31,000 per year at private colleges. Multiply that by six years — the typical length of time it takes students to earn a bachelor’s degree, according to the U.S. Department of Education — and you’re talking about a big number. And that doesn’t include housing, food and transportation.
But this is probably not news to you. Chances are you know a thing or two about student loan debt. And you also know that there are some deductions from that big-ticket price. Things such as scholarships, grants and perhaps a student’s part-time job.
How much do you need to save?
Taking that large number and breaking it down to a monthly savings goal can help you make a solid plan of action.
Let’s take a look at the numbers. Expecting college costs to continue growing, say you want to cover $50,000 in annual college costs for four years when your baby turns 18. Saving about $500 a month now, earning 5% along the way, should do the trick. You can massage the math yourself and play out any number of scenarios with this calculator.
It’s a long road from diapers to a diploma. Committing to a diligent college savings plan early can mean success later, based on small contributions over a long period of time. Several strategies are available to help you meet that goal.
529 college savings and prepaid plans
So-called 529 plans are the most popular education-specific savings plan, and growing. They come in two flavors: as an investment savings account or a prepaid tuition plan.
A 529 savings account allows you to invest in mutual funds or exchange-traded funds that carry the same risk/return profiles of other stock-and-bond-based investment accounts. Meanwhile, prepaid tuition plans allow you to effectively “lock in” tuition costs and avoid the impact of ever-increasing fees. Let’s take a look at both options.
529 savings plans
529 savings accounts allow you to set aside after-tax contributions that grow tax free, similar to a Roth IRA but with much higher contribution limits. The proceeds can be used for qualified educational expenses, such as tuition, room and board, and books. That doesn’t include general living expenses and buying a car for college. Such nonqualified expenditures will be taxed — and accrue a 10% penalty.
Although investment brokers often pitch 529 plans offered by a particular state, it’s a good idea to check your home state plan first. Many states offer tax breaks or credits to residents, and some even kick in matching funding as an additional incentive. The savings can be used at any college for qualified education expenses, not just those located within the resident’s home state.
Buying a plan through a broker also usually means paying higher embedded fees, though you’ll often receive guidance on how to invest. However, 529 plans purchased directly from a state’s college savings website can mean lower fees — and you can often choose from age-based prefab investment plans that adjust the investment mix with the child’s age.
529 prepaid tuition plans
College tuition rises an average of 5% annually, according to the College Board. One way to “lock in” your tuition costs is by tapping a 529 prepaid tuition plan. By paying in advance all or part of the costs of attending a particular university — or, in some cases, a group of institutions participating in a particular plan — you can avoid future tuition hikes. For example, you might pay for eight semesters in today’s dollars; that will allow you eight semesters in the future, even if the costs at that time are higher.
Sounds a bit too good to be true, doesn’t it? In fact, some educational systems have realized just what a bargain these have turned out to be and have terminated their prepaid plans. Some plans are continuing to operate but are closed to new students. There are increasing restrictions being placed on other prepaid tuition programs and even some concerns being voiced about their future financial viability.
High contribution rates, generally with no household income limits or age restrictions. Though contribution limits vary by state, typically up to $300,000 in lifetime total contributions are allowed.
Beneficiary flexibility. The account can be designated, and changed in the future, for the benefit of any individual’s education expenses — even your own.
If the parent is the account holder, it is considered a parental asset, with little impact on financial aid awards.
Since the 529 is dedicated strictly to educational expenses, if your child decides not to go to college or qualifies for something close to a full ride with scholarships, the money may be unavailable for other purposes. (Though you can change the beneficiary to another family member — or pay the tax and a 10% penalty on the growth of the assets.)
Stock market exposure can impact returns in a down market, particularly in the period of time close to when you plan to tap the funds. Keep a close eye on the risk being taken overall, especially as the beneficiary nears financial need.
Although 529 plans are the most popular way to save specifically for educational expenses, there are other choices too, each with their own advantages and disadvantages.
Nearly two-thirds of Americans use regular savings or checking accounts to set aside money for their children’s education, according to Sallie Mae. Although providing little in the way of interest, these accounts do offer flexibility, but that can also be a drawback. Tapping the accounts for non-college-related expenses with the hope of replenishing the funds later can result in a depleted college fund.
Few, if any, tax benefits and low returns, many times well below the rate of inflation
Using the tax-advantaged Roth IRA as a combination retirement account and educational savings vehicle offers numerous benefits and some flexibility. Since your after-tax contributions grow tax free, you gain maximum growth potential. You also have the ability to invest in a virtually unrestricted array of stocks, bonds, mutual funds and exchange-traded funds of your choosing, with or without the aid of an investment advisor.
Withdrawals from a Roth are allowed penalty free for qualified education expenses, though they will generally be included as income in determining financial aid eligibility.
If your child scores a bunch of scholarships and doesn’t require a lot of financial help, your retirement savings are allowed to stay invested.
Contribution amounts are limited to annual maximums and there are income restrictions as well. Plus, tapping your account for qualified education expenses can permanently hinder your ability to stay on track for your retirement savings goal.
If you are under 59 1/2 — or haven't had the account for at least five years — you'll pay taxes at your ordinary income tax rate on the investment earnings, unless you withdraw only your contributions.
COVERDELL EDUCATION SAVINGS ACCOUNTS
Education Savings Accounts, or ESAs, are a bit like a 529 with training wheels. Yes, qualified withdrawals are tax free and, as with a Roth IRA, you can buy a wide variety of investments. But contributions are limited to $2,000 per year, and only until the beneficiary turns 18. And there are income limitations too.
Although potentially meager in their growth potential, ESAs do offer more flexibility than 529 plans. Qualified expenses in Coverdell accounts can include educational expenses throughout the life of your child, from K-12 all the way through grad school.
A wide variety of available investments and tax-free growth.
The beneficiary changes are not as straightforward as with a 529 account and can vary by custodian (the financial firm hosting the account) — and all assets must be distributed to the beneficiary by age 30.
CDS, U.S. SAVINGS BONDS
In these days of low interest rates, certificates of deposit (CDs) and U.S. savings bonds have fallen out of favor. But for very conservative contributors, laddering such investments can still be an option, at least for a portion of the savings goal. This can also offer some flexibility in terms of cash flow, as the portfolio doesn’t mature all at once at some future date.
Series EE and I savings bonds feature an education tax exclusion allowing the interest paid to be excluded from gross income for bonds redeemed for qualified higher education expenses. There are some restrictions. Full details can be found at TreasuryDirect.
Minor, or no, tax benefits and low returns
This is how college savings worked back before there were 529s and ESAs. Trust accounts, structured as UTMAs or UGMAs, are assets transferred to a child’s account and invested on his behalf until he reaches the “age of trust termination,” as defined by the state in which he lives, usually between 18 and 21. And there’s the catch. As soon as they become adults, beneficiaries can do whatever they wish with the proceeds: pay for college or buy a sports car. And because the assets come under the student’s control, the value of the account will likely affect financial aid qualification.
Flexibility to use the account for more than just college expenses.
Some tax advantages to the donor.
Flexibility to use the account for more than just college expenses.
Beneficiary can’t be changed.
Saving for college can mean a combination of strategies
Although 529 plans have gained favor as a tax-efficient and fairly flexible way to save for college, the right answer for you may be a combination of different accounts. Perhaps a 529 and a Roth IRA. Or an ESA and a UTMA. It all depends on your long-term goals, the number of potential beneficiaries in your future and your particular income and tax situation.
Starting early gives you even more options. And saving for college can be a family affair: Grandparents are often happy to contribute to a college fund, utilizing their annual gift tax exclusion.
And although your aim may be to avoid saddling your baby and potential future collegian with student loan debt, nobody said she couldn’t pitch in with a bit of her own initiative over the next 22 years or so, right?