There's a reason the average class of 2016 graduate came away with $37,172 in student debt. Given the exorbitant cost of college these days, many students and their families just can't afford those hefty tuition bills, so they're forced to take out loans to finance their education.
Avoiding large levels of debt often boils down to having adequate savings -- a responsibility that tends to fall on parents more so than students themselves. And in that regard, Americans seem to be doing a pretty respectable job. As of 2016, in fact, 72% of U.S. families were actively saving for college, which represents a 14% increase from 2007, according to a report by Fidelity.
But there's some bad news to throw into the mix as well: Although more folks are setting money aside for college, only 42% are saving via a 529 plan. And those who aren't could be making a huge mistake.
Supercharge your savings
Though 529 plans aren't the only option for saving for college, there are numerous benefits to going this route. First and foremost, the money you invest in a 529 gets to grow tax-free provided you use it for higher education purposes. With a traditional brokerage account, any money you earn from investments is subject to capital gains taxes, which means you'll lose a portion of your earnings to the IRS and have less cash available to cover those tuition bills. You'll also be liable for those taxes year after year, which will leave you with less money to reinvest during your college savings window.
In addition to tax-free investment growth, some states offer tax deductions for participating in a 529. A few states even offer tax credits, which are more lucrative than deductions on a dollar-for-dollar basis.
Of course, the one major drawback with a 529 is that if you don't use the money in your account for qualified higher education purposes, you'll be subject to a 10% penalty. That penalty, however, is only applicable to your gains, and not your principal contribution. Say you fund a 529 with $40,000 of your own money, and that over time, your balance grows to $50,000. If your child decides not to go to college, you'll only be penalized on the $10,000 you earned but didn't contribute directly.
Despite this one disadvantage, it pays to look into saving with a 529, especially if your other choice is to stick that money in a traditional savings account. Imagine you're saving $500 a month for college over a 10-year period, but you put that money into a savings account paying 1% interest. After a decade, you'll have about $62,800, which isn't much more than the sum of your principal contributions.
Now watch what happens when we stick that same money into a 529. If your investments yield a relatively conservative 6% average annual return, after 10 years, you'll have over $79,000. That's a huge difference. Furthermore, that $79,000 will be yours to withdraw tax-free provided you're actually using it for college.
Of course, 529 plans aren't for everyone, but it still pays to save for college in the most tax-advantaged manner possible. In this regard, Roth IRAs are also a good bet for meeting your goals. Like 529 plans, Roth IRAs get to grow tax-free, and although they're designed for retirement, because you don't get a tax break for contributing, you're allowed to withdraw your money at any time to pay for other expenses, like college.
Even if you're not eligible for a Roth IRA (namely, because you earn too much money), you can instead fund a traditional IRA for college savings purposes. Traditional IRAs offer the immediate benefit of tax-free contributions, and while you'll typically face a 10% penalty for withdrawing funds prior to age 59 1/2, an exception is made when the money is used for qualified college expenses.
No matter how you choose to save for college, the key is to not only start doing so early but also efficiently. If a 529 plan doesn't appeal to you, consider saving in a traditional or Roth IRA instead. This way, if you don't end up needing that money for college, you'll be able to set it aside for retirement. Just don't make the mistake of saving in a regular savings account, or even a traditional brokerage account, which might mimic the returns of a 529 or IRA but offer no tax benefits to speak of.
An estimated 49% of families say that despite their efforts, they're not on track to reach their ultimate college savings goals. The more strategic you are about saving, the greater your chances of covering your costs, or at least coming relatively close.
The Motley Fool has a disclosure policy.