Choosing the Right College Savings Plan for You
Choosing the right college savings account for your child could help them afford their dream school.
College can be an exciting time. But with the average undergraduate student borrowing nearly $30,000, affording college may add to their stress load (and yours).
That’s why building a college fund could make a huge difference in helping your child afford college and reduce debt after they graduate.
There are several saving options that may help you prepare for your child’s future. Some of the most common college specific accounts used are 529s and Coverdell education savings accounts.
There are also alternative options, like savings accounts and brokerage accounts, that may help you save for your child’s future, whether they go to college or pursue other opportunities.
Not sure which college savings option is right for your family? Let’s explore the options. And if you have more questions, consult a financial or tax advisor to discuss your unique situation.
College savings accounts may help you set aside money for your child’s future.
Some accounts restrict how money is used, limiting it to education-related expenses.
You may choose to have more than one type of account to save for college.
College Saving Fund Options
With the rising cost of college, saving for your child’s future education is probably on your mind. Let’s dig into the most common college saving accounts.
529 savings plans are probably what you think of when someone mentions a college savings.
Funds in a 529 account are invested in the stock market. Each plan offers its own investment options, and often include mutual funds, exchange-traded fund (ETF) portfolios, and target-date portfolios.
You direct the investments according to your personal risk tolerance. As with any investment, your returns aren’t guaranteed, so your child’s educational savings may rise and fall with market performance.
529 plans offer a unique tax benefit where you don’t pay federal taxes on disbursements, provided they’re used to pay for qualifying education expenses.1 If your 529 investment does well, that could be good news, as investments may grow funds faster than a savings account! Additionally, some states allow you to deduct your contributions from your state income tax liability.2
Disbursements from 529’s may be used for education and living expenses during undergraduate and post-graduate years.3 And up to $10,000 may be used for tuition expenses at elementary or secondary schools.4 If your child doesn’t use the funds, you’re able to change the beneficiary to another child or grandchild.
It’s worth noting that there are contribution limits on these accounts, ranging from $230,000 to $550,000 depending on your state’s regulations. If you have questions about 529s, consult a financial or tax advisor for more information.
Custodial accounts are savings or investment accounts opened and managed by an adult on a child’s behalf.
Some custodial accounts, like Coverdell education savings accounts, only allow the funds to be used for college expenses. Other custodial accounts, like Uniform Gifts to Minors Act and Uniform Transfer to Minors Act accounts, have fewer restrictions on how the assets could be used.
The adult is responsible for all aspects of managing the account, from overseeing contributions and deposits to picking investments (as applicable) until the child becomes an adult.
Additionally, some custodial accounts require the minor’s parents or guardians to file a tax return on the child’s behalf. If the account’s earnings exceed a certain threshold, the child may owe the “Kiddie Tax”.5 While the “Kiddie Tax” is typically lower than other income tax rates, it could have a significant impact on the child’s tax liability if the account’s earnings are significant.
Custodial accounts may impact a child’s financial aid eligibility. While 83.8% of students qualify for at least some financial aid, the Free Application for Federal Student Aid (FAFSA) calculations factor a portion of the money in custodial accounts into a person’s financial aid eligibility.6˒7
Coverdell Savings Accounts
Coverdell education savings accounts (ESAs) are a type of custodial account or trust that allow you to set money aside for education expenses. They function similarly to 529 accounts but have a few more restrictions in place on how the money may be used and how much you are able to contribute each year.
One of the main drawbacks of an ESA is the contribution limit. You’re only allowed to contribute a maximum of $2,000 per child per year, depending on your modified adjusted gross income, and those contributions aren’t tax-deductible.8
However, compared to 529s, these accounts usually have more diverse investment options. Some people prefer having more investment options to help manage risk.9
Distributions from Coverdell ESAs are tax-free if used to pay for qualified education expenses.
Additional College Savings Options
Custodial accounts, Coverdell ESAs, and 529 accounts are all great options to help you build a college fund for your child.
But you may also want to consider other ways to increase your child’s college savings, like high-yield savings accounts, retirement accounts, and brokerage accounts.
Let’s take a look at these options.
High-Yield Savings Accounts
A high-yield savings account could be a very flexible way to save for your child’s future, whether it includes college or not.
When you open a savings account, there are no restrictions on how you could use the money. This means you’re free to open one for your child’s education fund or any other savings goal you have in mind. Even better, your child may use the funds for any purpose if they decide not to go to college, and having this money on hand could help set them up for a healthy financial future.
When choosing a savings account, look for one with a competitive rate that may help your savings grow quicker over time.
If you have some time before your child leaves for college, you may also consider a certificate of deposit (CD). CDs generally offer higher rates than savings accounts in exchange for locking your money away for a set term.
Keep in mind that the FDIC only insures up to $250,000 per depositor, per ownership type, per financial institution.10 If you’re planning on saving more than $250,000, you may want to open an additional savings account at a different bank or under a different ownership type to access additional FDIC insurance.
IRAs and 401(k)s
Some people may choose to use funds from a retirement account to help pay for their child’s education.
You may not realize this, but you are allowed to withdraw funds from traditional and Roth 401(k)s as well as IRAs and avoid the early withdrawal penalty if you’re using the money to pay for college. Distributions from retirement accounts are usually subject to a 10% early withdrawal penalty for disbursements taken before 59 ½ years of age. However, education expenses are an exception to this penalty, allowing contributions to be withdrawn early and penalty-free, if the money is for education expenses.11
Here are some considerations, but it’s always important to speak with your tax and financial advisors to get the full scoop.
Money taken from traditional accounts is still subject to income taxes, whereas funds taken from Roth accounts aren’t subject to income tax because those contributions were made with after-tax dollars. Therefore, it’s usually more advantageous to use Roth accounts if you have them.
Whether you choose to take funds from a traditional or Roth retirement account, you are only able to withdraw contributions, not earnings.
Taking money out of your retirement accounts means that you could set back the growth trajectory of your retirement savings.
Another note: using funds withdrawn from IRAs may impact the student’s financial aid eligibility.12 If receiving financial aid is an important component of affording college, be sure to understand the financial aid rules thoroughly before taking any action.
Many families invest directly in the stock market to save and potentially earn college funds and they do so via a brokerage account.
When you open a brokerage account, you direct how your money is invested and may use the funds without restriction. But unlike certain college savings accounts, such as 529s, brokerage accounts don’t offer tax-free withdrawals for education expenses.
It’s also worth noting that brokerage accounts may also impact your child’s financial aid eligibility and could influence how much aid they receive.13 Again, familiarize yourself with financial aid rules if financial aid is part of your overall plan for paying for college.
Comparing Your College Savings Options
The 529 Plan
Coverdell Education Savings Accounts
Custodial Savings Accounts
High-Yield Savings Accounts
Offer tax-free disbursements
Contributions may be tax deductible
More diverse investment options than 529s
No restriction on how money could be used
No early withdrawal penalty for education expenses
No restriction on how money could be used
Control over investments
Must be used on qualifying education expenses
Contributions are not tax deductible
Low contribution limits
High impact on financial aid eligibility
Impacts retirement savings
Rate of return may be lower than investments
May impact financial aid eligibility
Between $230,000 and $550,000, depending on the state
$2,000 per child per year
In 2023, $6,500 - $7,500 depending on age14
Which Savings Method Is Right for Your Family?
Any of these college savings accounts could help you set money aside for your child’s college expenses, but one account may work better for your needs than the others. Before you start, consider the following factors.
Risk tolerance: Investment accounts are subject to market performance. Consider how much risk you’re comfortable with before you open an account. The amount of time your account has to absorb market risk may also be a factor.
Your child’s age: The younger your child is, the more time you have to contribute to the account. Consider the contribution limits each account has and how much you’re able to contribute each year until your child goes to college.
Tax implications: Some accounts have tax-free disbursements while others don’t. Consider how those tax implications could impact your finances.
Financial aid considerations: Custodial accounts, regular savings accounts, and brokerage accounts could impact your child’s financial aid eligibility. Consider whether your child may need to file for financial aid and how much they’re likely to need before you open an account.
Flexibility of use: Many college-specific savings accounts restrict how your child may use the money. Before you open an account, consider if you think your child is likely to go to college or may need more flexibility with the money.
Try combining more than one approach—having a combination of accounts could mean you and your child have more flexibility.
If you’re not sure what the right choice is for your family, consider consulting a tax professional or financial advisor to help you choose.
Paying for college may seem daunting. But choosing the right savings methods for your family could give you some peace of mind for the future. No matter which plan you choose, whether it’s a single 529 account or a combination of several types, getting started today may help you help your child reach their future goals.