Given that college costs seem to be going nowhere but up, a growing number of families are taking steps to set aside funds to cover their children's expenses. The problem? They're saving inefficiently.
Nearly 75% of parents are housing their college money in a regular savings account, according to new data from Student Loan Hero. Meanwhile, only about a quarter of parents are stashing their college savings in a 529 plan.
Of course, 529s aren't the only effective means of saving for college, but they most certainly beat regular old bank accounts. And the sooner parents start to realize that, the better-equipped they'll be to make the most of their savings efforts.
529 plans: a superior savings option
Why save in a 529 over a traditional bank account? There are multiple reasons. For one thing, you don't get a tax break for putting money into the bank, but you do get tax benefits from a 529. Though the money you contribute goes in on an after-tax basis, once it's in there, it can grow tax-free. This means that if you contribute $60,000 out of pocket, and that sum grows to $90,000 over time, that additional $30,000 is yours to keep without having to give the IRS a portion. The interest you earn from a savings account, on the other hand, will be taxed as ordinary income, which means it'll be treated the same way as your regular paycheck. That's the opposite of a tax break.
But tax treatment aside, the problem with housing your college savings in the bank is that interest rates are abysmally low at present. These days, you'll be lucky to snag 1% annually on your money, which means that leaving your college fund in the bank will significantly stunt your savings' growth. A 529 plan, on the other hand, might easily return an average of 6% or more each year, helping you accumulate more cash for when those tuition bills start rolling in.
Here's how that difference might play out in numbers. Imagine you're able to set aside $300 a month for college over a 15-year period. If you keep that money in the bank at an average annual 1% return, by the time you need to use it for college, it will have grown to $58,000. But if you stick that cash in a 529 plan averaging a 6% return per year, you'll end up with $84,000. That's quite the difference.
Additionally, most states offer some sort of tax deduction for contributing to their plans, and some will give you a tax break for participating in any state's plan. But you won't see any incentives at the state level to put money into the bank.
An alternative to 529s
While 529 plans offer a number of benefits, their primary drawback is that they penalize you for saving too much. If you overfund a 529 and don't wind up needing your entire balance to pay for college, you'll face a 10% penalty on any amount withdrawn for purposes other than education. That penalty, however, applies to your investment gains only, and not the principal you contributed.
That said, if you'd rather not take the risk, there's always the option to save for college in an IRA, whether it's the traditional or Roth variety. The one drawback with IRAs is that they currently max out at $5,500 a year in contributions for folks under 50, and $6,500 a year for those 50 and over. But with either type of IRA, you're allowed to withdraw funds prematurely (meaning before age 59-1/2) without penalty, if that money is used to pay for qualified higher-education expenses for yourself or a dependent.
Furthermore, both IRA types offer tax incentives for making contributions. With a traditional IRA, your money goes in tax-free, and gets to grow tax-deferred. You will, however, pay taxes on distributions. With a Roth IRA, you don't get an immediate tax break for contributing, but as with a 529, your money grows tax-free so that when you take withdrawals, that money is yours completely.
Of course, if you're going to save for college in an IRA, your best bet is to distinguish between that account and the one you have earmarked for retirement. The last thing you want to do is blow your nest egg to cover your kids' tuition, and be left scrambling during your golden years. But just as a 529 plan might easily deliver a 6% average annual return or higher, an IRA is equally capable of doing that well or better.
Whether you opt to save for college in a 529, an IRA, or another account type, don't make the mistake of leaving that money sitting in the bank. Otherwise, you might easily come up short once those tuition bills become a reality.