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Types of College Savings Accounts

Types of College Savings Accounts

Paying for College
ELFI | April 15, 2022
Types of College Savings Accounts

Saving for a child’s college education is one of the best ways to set them up for success. Anyone who has graduated college with a massive student loan burden will tell you that life is harder when you’re deeply in debt.   But what are the best ways to save for college?

7 Best College Saving Options 

According to the Federal Reserve, the average student loan debt in 2021 totaled more than 1.7 trillion. There are a number of ways to save for a child’s education expenses, and the best choice will vary depending on your circumstances. Some people may start a college fund for their child, save on their own in the case their parents can’t or won’t pay for college, or receive help from grandparents or other family members. Ultimately, one of the best ways to save for college is to pay the costs directly using your savings. If you can afford it, this option can minimize the amount of loans you’ll take out, and therefore, your total interest owed. Learn More: Why Parents Should Pay for College

529 Plan

A 529 plan is a tax-advantaged account, which makes it one of the best ways to save for college. A 529 is like a special savings account designed for education-related expenses. Anyone can open and contribute to a 529, including parents, grandparents, family friends, and other relatives.    When the beneficiary is ready to attend college, they can withdraw 529 funds to cover tuition, room and board, and other educational expenses.   Other qualified 529 expenses include:

Qualified expenses include costs associated with both two-year and four-year colleges and vocational and trade schools. However, not everything will count as a qualified educational expense. For example, transportation costs are not eligible, even if traveling on campus.  When you contribute to a 529, you can invest the money so it will grow over time and reap the benefits of compound interest. Many 529 plans let you choose from various investments, just like a 401(k) or IRA.   Plus, most states offer a tax deduction or credit if you contribute to a 529 – but this benefit only applies to states that charge income tax. The following states do not offer a tax break for 529 contributions:

Keep in mind that there are also six states that charge income tax and still do not provide a tax break for 529 contributions:

There is no annual contribution limit to a 529 plan, but there is an aggregate limit that varies depending on the state. The general range is between $235,500 and $550,000.  The downside to a 529 is that the funds must be used for qualified education expenses. If you use the money for other costs, you may have to pay income tax and a 10% penalty. For example, if there are leftover funds in a 529 after your child has finished college, they can withdraw the funds and pay the income tax along with the 10% penalty.   However, you can also change the beneficiary on a 529 to another family member. For example, if you have multiple children and your first child has money leftover in a 529, you can change the beneficiary to the next youngest child. Pros of a 529 Plan:

Cons of a 529 Plan:

Coverdell ESA

The Coverdell Education Savings Account (ESA) is similar to a 529 in that you can use the funds tax-free for qualified education expenses.    The annual contribution limit with a Coverdell ESA is $2,000 per child, which is much lower than the limit for a 529. Also, you can only contribute to a Coverdell ESA account if the child is younger than 18, while there is no age limit with a 529. Pros of a Coverdell ESA:

Cons of a Coverdell ESA:

Custodial Brokerage Account (UGMA/UTMA)

A custodial brokerage account is a trust account where parents can put money for a child’s benefit. The parent will then manage the account and can invest the funds.    Money in a custodial brokerage account will automatically become the child’s property when they turn 18 or 21, depending on their state. Once they become an adult, the account becomes theirs, and they can use the funds for anything they want.    The downside to a custodial brokerage account is that it will have a bigger impact on how much financial aid a student receives. For example, only 5% of the money in a 529 will be counted when calculating the student’s assets. However, 20% of the money in a UGMA or UTMA will be counted. This can disqualify the student from receiving some types of financial aid.   The benefit of custodial brokerage accounts is that you can use the funds to pay for anything, not just education-related expenses. If your child wants to graduate high school and start a business, they can use UTMA funds to do so without a penalty.    There is also no annual contribution limit to a custodial brokerage account, but parents who give more than $15,000 (or $30,000 for married couples) will have to pay a federal gift tax. Pros of Custodial Brokerage Accounts:

Cons of Custodial Brokerage Accounts:

Qualified US Savings Bonds

If you’re looking for a secure way to invest in your child’s education, US savings bonds may be the right choice. These funds are backed by the government, meaning these are less risky than traditional investments. These types of accounts also offer tax advantages on both federal and state levels. Pros of US Savings Bonds:

Cons of US Savings Bonds:

Roth IRA

You can also consider using a Roth IRA to pay for college. Contributions to a Roth IRA can always be withdrawn tax-free, and there are no limits on what those funds can be used for.    Roth IRAs also have more investment options than 529s. You can put the money in individual stocks like Google and Apple or in index funds. You may also be able to find funds with lower fees than you can with a 529.   The annual contribution limit to a Roth IRA is also lower than a 529, at $6,000 per year or $7,000 if you’re 50 or olderPros of a Roth IRA:

Cons of a Roth IRA:

Prepaid Tuition Plans

If you know which college or university your student will attend, you may be able to pay tuition in advance. This option isn’t available everywhere, so your selection may be limited if you’re interested in paying for college this way. The benefit of this type of plan is that, even if the cost of tuition rises, your year of school will already be covered, and you won’t be asked to pay the difference. The drawback is that your student will still be responsible for costs outside of tuition, like housing, textbooks, and food. Pros of Prepaid Tuition Plans:

Cons of Prepaid Tuition Plans:

A Regular Savings Account

One of the best ways to pay for college, if you can afford it, is to use funds from your savings account. By taking on a part-time job or a side hustle in high school, you may be able to offset the cost of college by using the money you’ve already saved to pay down your fees. While paying college costs entirely from your savings may not be feasible, any amount you can afford can help lessen the total student loan balance you’ll need. Pros of Savings Accounts:

Cons of Savings Accounts:

How to Choose the Best College Savings Option for You

Choosing from one of the many college saving options can be difficult because there’s no one right answer for every family.    The best way to pick a college savings plan is to meet with a financial planner who can recommend a plan based on your financial situation. They can also help you understand the possible financial aid and tax implications of each plan. 

When to Start Saving for College

If you’re looking for the best ways to save for college, now is the time to start your research. The sooner you can begin to plan or accrue funds to cover your educational expenses, the more you’ll have saved when the time comes to pay your tuition.

How Much Should You Save for College?

While the exact number you’ll need to save may vary based on the school or major you choose, it’s important to plan ahead to be ready for college costs. Research the cost of attendance at your chosen school – or if you’re saving for a child who isn’t old enough to think about higher education, look into the average cost of college as a starting point. It is generally recommended that you ⅓ of your total payment in a designated account ahead of time, so you’re only responsible for paying the remaining ⅔ through your income and loans. If you can save more, that’s even better!

Other Ways to Avoid or Reduce Student Debt

Outside of savings, there are many additional options that may help you reduce or avoid taking out student loans, such as:

Scholarship Resources:

Consider Student Loans if Your Savings Don’t Cover Tuition

If you can’t afford college tuition using only your savings, consider applying for federal student loans via the FAFSA, or applying for private student loans. ELFI offers private student loans with affordable interest rates and flexible repayment terms, as well as student loans for parents. Ready to learn more? Visit our private student loans for college page.