If you'd like to pay for your children to go to college but are worried about the costs, you're not alone. For a child born now, it is estimated that it will cost between $100,000 and $150,000 to pay for four years of college, so it's definitely an understandable concern. Fortunately, there are ways to make it easier if you're willing to get started early.
Through tax-advantaged investment account options such as 529 plans, Coverdell ESA, and Roth IRA, you can save for college and let the magic of compound investment gains do the hard work for you.
Too many people save for college the hard way
According to The Wall Street Journal, the most popular way Americans save for college expenses is with regular savings accounts, used by 45% of families as part of their college savings plan.
The issue is that savings accounts are a poor choice for college, or any long-term savings plan, for that matter. In the first case, savings accounts earn virtually no interest right now. Many big banks' savings accounts pay interest rates as low as 0.01%, and even the highest-paying accounts from credit unions and online banks pay in the neighborhood of 1%. So, your money grows over time at an anemic pace.
Additionally, inflation will erode your purchasing power over time, and actually make the money you save worth less as time goes on. The average inflation rate over the past 18 years has been about 2.3%, so even if your savings account pays 1% interest per year, you're actually losing 1.3% in purchasing power every year. Over the 18-year span between when a child is born and when they reach college age, this means the money you contribute to a savings account now could be worth 26% less by the time your child is ready for college, even after the interest you earn.
529 plans: The easy way to save
A 529 plan is a tax-advantaged way to save for college and in my opinion is the most hassle-free of the three options presented here.
529 Plans are issued by the individual states and come in two varieties: prepaid plans and savings plans. Only 10 states are currently accepting new prepaid participants, so I'll focus on the savings option.
A 529 savings plan allows you to contribute money, and your contributions grow tax free until your child needs the money for college. And, while contributions aren't deductible on your Federal tax return, withdrawals that pay for qualified higher education expenses are tax free. Furthermore, the individual state issuing the plan may offer its own tax incentives for contributing.
Once you contribute, you choose from several investment profiles (aggressive, conservative, etc.), and the plan does the rest. You simply continue to make contributions, sit back, and watch the money grow.
529 plans are also the most generous when it comes to contribution limits. Overall limits vary from plan to plan, but are typically in the $300,000-$400,000 range, by far the highest of the three options discussed here.
Coverdell ESA: Flexible investments and can be used for any level of education
Coverdell Education Savings Accounts (ESAs) are even less well-known and widely used than 529 plans, but offer several unique advantages.
For one thing, money saved in a Coverdell can be used for any qualified education expenses, not just college. So, if you decide to send your child to a private high school, you could use the money you've accumulated in your Coverdell to help pay for it. And unlike a 529 plan, a Coverdell lets the account owner invest in virtually any stock, bond, or mutual fund they choose, which allows for more control over your investment strategy.
On the downside, Coverdell accounts have much lower contribution limits than 529 plans. Currently, contributions to a Coverdell are limited to $2,000 per year, so a Coverdell account alone might not be enough to cover all of the expenses associated with four years of college.
As far as tax treatment is concerned, the account is similar to a 529. Contributions are not deductible, but withdrawals for qualified educational expenses are tax free. The only difference is the expanded definition of what qualifies, as I mentioned earlier.
Roth IRA: Similar benefits to the others, but your money isn't committed
A Roth IRA has a similar tax treatment to 529 and Coverdell accounts in that contributions aren't tax deductible, but all qualifying withdrawals are tax free. And, even though the primary purpose of a Roth IRA is to save for retirement, they can be effective tools for college planning as well.
Generally, if you withdraw money earned in a Roth IRA before turning 59 1/2 years old, you'll be subject to a 10% penalty from the IRS. However, by using the money for qualified higher education expenses, there is no such penalty.
The main reason to consider using a Roth IRA as a college savings vehicle is for the flexibility it gives you. In other words, if your child doesn't go to college or doesn't need all the money you've set aside, you can simply leave it in your Roth IRA and let it continue to grow for your retirement.
However, there are some drawbacks to this method as well. For starters, there is no possibility of state tax benefits that you might be entitled to with a 529. And, there is a contribution limit of $5,500 per year ($6,500 if over 50) for all of your IRA contributions. So, by choosing to save for college this way, you limit your ability to save for your own retirement.
Which is the best for you?
The answer to this question depends on how much you plan to save and whether or not you have an alternative beneficiary that could use the account in the event your child doesn't go to college. For example, I prefer the Coverdell account because of the freedom to choose from thousands of different investments and the flexibility to use the money for educational expenses before college. However, $2,000 per year might not be enough, so I also use a 529 to bridge the gap.
In other words, the best possible way you can save for your child's education is likely to be a combination of these options. All three are great ways to start saving for your child's education, and starting as early as possible is even more important than which one you choose.