For those of you who don’t know, my husband and I had our first baby on July 15th, so things have been quite busy. Now that we are finally starting to settle into a bit of a rhythm, I actually have time to sit down and write. I posted my first article on Seeking Alpha discussing the setup our daughter’s portfolio and the first stock we purchased for it. If you’re interested you can read the full article here. As I was writing that article, I found myself wondering what is the best, or most financially savvy way to save for our child’s college education? I decided to put together a list of 5 ways to save for your child’s college education.
Option 1: 529 Account or Plan
This is probably the most popular option out there for parents to save for their child’s college education and there are a lot of benefits to 529 plans. For example, there are a number of tax benefits associated with 529 plans. While contributions to a 529 plan are not deductible, any earnings generated from the contributions grow tax free at the federal level, as long as the proceeds are used to pay for the qualifying college expenses.
Further, depending on the state you live in, you may also be able to avoid paying state taxes, as well. Over 30 states offer some kind of state tax benefit for using a 529 plan to save for college.
Another benefit of 529 plans is that the parents, in most cases, maintain the ownership and rights to the account. The beneficiary, typically your child, has no legal rights to the funds so you are able to ensure that the money goes to college and not to a new car, or in the year 2039 maybe some kind of hovercraft, who knows.
Yet another benefit of 529 plans is that they are typically low maintenance and the investment options available are typically mutual funds, ETFs, index funds and the like. In other words, the active management of the account is handled by outside companies, like Fidelity or T. Rowe Price; therefore, there is little for you to do.
The last benefit of 529 plans is that they are flexible in the sense that if you have multiple kids and one decides they will not go to college, you can transfer the funds over to your other child to use for college; in fact, you can transfer the funds over to any qualifying dependent.
While there are a lot of advantages to 529 plans, there are also some downsides. For instance, if you are an active investor and want control over the portfolio, 529 plans don’t allow for individuals to pick and choose stocks or other asset classes to include in the plan. As stated in the paragraph above, you are required to pick from the predefined investment options offered by the company you are using for the 529 plan.
Another drawback to 529 plans is that if you need to withdraw the funds for something other than a qualifying college expense, you will be forced to pay taxes on the earnings or gains generated, as well as a 10% penalty. This is difficult if you are creating a portfolio for your child for them to use for more than just qualified educational expenses.
The other potential disadvantage is that 529 plans can be more difficult, especially when it comes time to do your taxes, than other saving options out there.
Option 2: Coverdell Education Savings Account
These accounts are very similar to 529 plans; however, there are some distinct differences. A Coverdell Education Savings Account (Coverdell ESA) is a trust or custodial account set up in the United States solely for paying qualified education expenses for the designated beneficiary of the account. This benefit applies not only to qualified higher education expenses, but also to qualified elementary and secondary education expenses. As with 529 plans, the earnings and withdrawals in these accounts are tax free as long as they are used for qualified educational expenses.
One big difference between a 529 plan and a Coverdell ESA is that these accounts typically offer more flexibility than 529 plans. In addition to tuition for primary and secondary schools, savings from a Coverdell ESA can cover school uniforms, tutoring programs and other K-12 related expenses without triggering a penalty.
There are also disadvantages to Coverdell ESAs. For example, the contribution amount for these types of accounts is capped at $2,000 per beneficiary a year. Additionally, contributions to a Coverdell ESA cannot be made for children over age 18 and all funds must be withdrawn by age 30.
Option 3: Roth IRA
A Roth IRA account may not come up in the list of standard ways to save for your child’s college education, but they have some advantages over some of the other options out there. The Roth IRA was setup to be a retirement account, which means that withdrawals from the account before the age of 59 1/2 are typically penalized. However, there are some key exceptions to the rule if you are using the withdrawals for college expenses.
Specifically, you can withdraw up to the amount you’ve contributed without taxes or penalties at any time and for any reason. For example, if you’ve contributed $100,000 to your Roth IRA and it’s grown to $150,000, you can withdraw up to $100,000 at any time without being penalized. You can also withdraw the earnings penalty-free (but not tax-free) if the money is used for college expenses for you, your spouse, your children or your grandchildren.
Another benefit of the Roth IRA is that, similar to 529 plans, the earnings in this account will grow tax free.
The biggest benefit of the Roth IRA option, in my opinion, is that it gives you more flexibility than just saving for college. With the 529 plan, the contributions and earnings must be used for qualified college expenses. With a Roth IRA, you can use those earnings and contributions not only for retirement or college expenses, but also to purchase a house, as an emergency fund or for qualified medical expenses.
Furthermore, with a Roth IRA you have more investment options than you do with a 529 plan. With a Roth IRA you are able to invest in anything you want, since you are actively managing the account.
There are also some downsides with using a Roth IRA for college, though. The first and biggest downside is that you lose out on a key account for retirement. In other words, if you are using a Roth IRA as a way to save for your child’s college education, then that is $5,500 a year that is not going towards your future retirement.
Also, the contribution limits on Roth IRAs are much lower than those of 529 plans. The other big drawback to using a Roth IRA for college education is that the withdrawals from the account are counted as income on financial aid forms for college.
Option 4: Educational Trust
Another option for parents to use is an educational trust account. A trust is set up when an individual wants to hold assets on behalf of or for another person with the intention of eventually handing those assets over. When parents create an educational trust, the terms of the trust indicate that the trust funds should be used to pay for educational expenses.
The main benefit here is that the parents maintain control over the account and can ensure that the funds in the account are used for education and not spent irresponsibly by the child.
Furthermore, trust funds give the recipients of the funds more flexibility. In addition to paying for school, the trust could stipulate that the funds can be used for other purposes later in life (e.g. wedding, home purchase, etc.). A trust can also be beneficial for parents who want to transfer assets and minimize their estate tax burden.
Consistent with the other accounts there are also some drawbacks to using trust funds for college expenses. The biggest drawback of using trust funds for college is that they lack some of the tax benefits that the other options offer. In some instances, both the parents and the beneficiary may end up paying taxes depending on the type of trust created and the amount of money or assets transferred into the account.
Option 5: Prepaid Tuition Plans
Prepaid tuition plans are another way that some parents may want to save for their child’s college education. The main benefit of a prepaid tuition plan is that it’s a tax-advantaged college savings program that allows parents to purchase, or “lock in,” college tuition amounts at current rates to cover higher education expenses when their child is of college age.
In other words, if a state college costs $15,000 per year today, you can lock that rate in and pay that same rate 18 years from now, even if the cost of that state college in 18 years may cost $25,000 per year. States operating the prepaid plans guarantee that the funds will rise in value as college tuition costs increase.
Additionally, prepaid plans retain the same tax, financial aid and parental protections as 529 college savings plans, but without being subject to swings in the stock market.
The biggest disadvantage of the prepaid plan is that the funds can only be used for certain state schools. For example, if your child decides to go to school out of state, while you will get a return on your money, the return will be less than the full value of the plan.
To illustrate this, let’s say someone bought one year of tuition at a New York State school for $20,000, but now tuition is up to $35,000. They would get a full year of college. If they decide to go to school in New Jersey, for instance, they would get a return — probably $22,000 or $23,000 — but they wouldn’t get the full $35,000.
In addition to all the options listed above, you can always save for college in a regular savings account, brokerage account or CD. Keep in mind, though, that with those options it is unlikely that you will receive tax benefits even if the deposit and earnings in those accounts are used solely for educational expenses.