Flickr / 401(k) 2012.
There are plenty of ways to put away money for your child's college education. You can stash money in a savings account, start an investment account, or you can even usually withdraw money penalty-free from a retirement account to help pay for college expenses.
However, the best way is to make use of your tax-advantaged savings options, such as a 529 plan or Coverdell Education Savings Account.
Each has its pros and cons, so here's a guide to help you decide which is best for you and your family.
529 plans are not all created equal
There are actually two distinct varieties of 529 plans, the savings plan and prepaid tuition plan. Both accounts let your savings grow without federal income tax liability, as long as you use the money for qualified education expenses.
The prepaid and savings plans are two very different ways of saving and accomplishing your objectives, so the best choice for you depends on what you and your child have in mind for his or her educational future.
Should you prepay for college now?
First of all, the prepaid 529 plan is not offered in every state. As of this writing, only 17 states offer prepaid tuition plans.
If you can get one where you are, it is basically a way of paying for future college tuition at today's rates, which can be a huge savings, especially if you believe tuition will continue its rapid rise. Over the past decade alone, college tuition has grown by nearly 80% on average, which translates to an average annual increase of more than 6%.
That's not a bad return for an investment which can never decrease in value, as long as the student attends a public college or university in the state the plan is based in.
However, that limitation is the major drawback. It doesn't leave much in the way of school choice.
What if your child decides to go to an out-of-state school or a private school. Different prepaid plans have different ways of handing money flowing out to other states or institutions, but the only way your full prepayment of tuition is guaranteed is by your child enrolling in an in-state public school.
A 529 savings plan lets you save lots of money without worrying about taxes
Similar to a 401(k), all 529 savings plans have a selection of investments to choose from, usually about a dozen, and your account's performance will depend on how well the investments perform. Every state but Washington offers a 529 savings plan, so these are the much more common type of account.
Also, the funds in a 529 savings plan don't need to be used for college expenses in the state where the plan is based. You can use the funds at any accredited college or university for expenses such as tuition, fees, room and board, books, and several other qualified costs of attendance.
The Coverdell offers more flexibility
A Coverdell ESA (education savings account) is similar to a 529 savings plan, but with a few important differences.
First off, the negative difference is that you can't contribute as much, which is why these are often used as supplements to other savings methods. You can only contribute $2,000 per year to a Coverdell, unlike 529's, which don't have an annual maximum. A 529 plan is generally limited by a lifetime maximum contribution, typically a six-figure amount.
However, there are a few benefits to Coverdell's. In a Coverdell ESA, you can invest in virtually any stock, bond, or mutual fund your brokerage offers. The investing rules are similar to those of an IRA, not a 401(k).
Also, the funds in a Coverdell ESA can be used for any qualified educational expense such as a private elementary or secondary school, not just for college.
So, what's the best move for you?
If you're reasonably sure your family will stay put in the same state until your children go off to college and will attend an in-state public institution, a prepaid tuition plan may be the way to go.
If there is a reasonable chance you'll move, want to save for other expenses like books and meal plans, and want to leave open the option of attending an out-of-state or private school, the other plans are probably the best bet. The 529 plan allows you to contribute more, but the Coverdell ESA gives you the flexibility to use the funds for any qualifying educational expenses, not just college.
In a nutshell, the best move for you and your family depends on your particular set of circumstances and the options you want to leave open to your future college student. Whatever you do, start as early as possible.
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