When you have a child, you want to give them every opportunity to succeed in life. Since a degree can open up more employment opportunities and result in a higher salary, going to college is often an important step on the ladder.
But as we all know, college isn't cheap. According to Experian, the average student loan debt was $35,359 in 2018. College costs have also been steadily rising for decades, so if you have a young child or you're currently expecting a baby, it's likely that they'll need to pay much more for school.
By starting a college fund for your child, you can help them get an education without ending up with too much student loan debt. The question many parents ask is: What financial tool should I use to save that money? And fortunately, there are a few excellent options available.
A 529 plan is a state-operated college savings plan, although funds from this type of plan can also be put toward tuition for any school year, from kindergarten to 12th grade. You're allowed to open a 529 plan in any state, whether or not you are a resident. Funds from a 529 plan can also be used for college in any state, as well as for some international universities.
If a 529 plan is used for qualified educational expenses, then withdrawals are tax-free.
There are two types of 529 plans available:
- Savings: The money you deposit is invested, with the most common investment option being a mutual fund. Your money then grows in value with the investment.
- Prepaid: You use your money to buy college tuition credits at today's prices so that your child doesn't need to pay higher tuition costs in the future.
One benefit of 529 plans is that they have high contribution limits. There is no annual limit, and the maximum amount you can add to a 529 plan is determined by the state, with limits ranging from less than $250,000 to more than $500,000.
A 529 plan is a smart choice if:
- You want to contribute a large amount of money to your child's college fund.
- You've started your child's college fund early (at least 10 years before they'll need it), and there's plenty of time for the money to grow.
Coverdell Education Savings Account (ESA)
A Coverdell ESA, also known as an Education Savings Account, is an investment account intended for educational expenses, which can include expenses for college, or kindergarten through 12th grade. Distributions from the plan are tax-free. There is a contribution limit of $2,000 per year per beneficiary.
There are also income restrictions to consider when contributing to an ESA. As of 2019, the amount you can contribute is phased out if you're a single filer with a modified adjusted gross income (MAGI) between $95,000 and $110,000 or if you're a couple filing jointly with a MAGI between $190,000 and $220,000.
Since this type of plan is intended for education expenses, if funds are withdrawn for any other reason, there is a 10% penalty and the beneficiary will pay income taxes on the plan's earnings. The beneficiary must also use the funds by the time they turn 30. If they don't, you have two options:
- You can roll over the funds to the ESA of another family member who is under the age of 30.
- The beneficiary can withdraw the funds within 30 days of turning 30, although they will need to pay the aforementioned penalty and income taxes.
A 529 plan is usually a better choice than an ESA, but there are a couple of situations in which you may want to open an ESA instead:
- You'd like more investment options. With a 529 plan, you are limited to the investments available with that specific plan, whereas ESAs let you invest in almost any stock, bond, or mutual fund.
- You might need to use your plan for your child's expenses in kindergarten through 12th grade. A 529 plan can be used for tuition at these schools, but not for other educational expenses, such as books and tutoring.
Individual retirement account (IRA)
Although an IRA is obviously intended for your retirement savings, it can also work well as a college fund. There is usually a 10% penalty for withdrawing from an IRA before you reach age 59½, but you can avoid this penalty by using the funds for qualified college expenses.
There are two significant advantages to choosing an IRA over a 529 plan or an ESA:
- Unlike college savings plans, IRAs are not included in a student's financial aid calculations, so they cannot reduce the amount of financial aid your child receives.
- College savings plans have penalties for when the funds aren't used for educational expenses, even if the beneficiary didn't need all their funds. With an IRA, you can simply use the unused funds for your retirement.
However, there are also some important disadvantages to this option:
- 529 plans and ESAs allow tax-free withdrawals. With a traditional IRA, you'll pay federal and state income taxes on your full withdrawal. With a Roth IRA, you'll pay those income taxes on any earnings beyond what you've contributed to the account.
- You can't use IRA funds for expenses from kindergarten through 12th grade.
- You'll end up with less money for retirement.
Because of these drawbacks, this option is only recommended if you:
- Are already saving plenty of money for retirement.
- Don't want to tie money into a college savings plan and risk a penalty if your child doesn't need all of it.
Choosing the right college fund
So, which of these college fund options should you go with? For most, a 529 plan will be the way to go, since it offers tax-related advantages and very high contribution limits.
That being said, you could find that an ESA or IRA fits your needs better. Both offer more investment options, and an IRA will allow you added flexibility in how you use your funds.
But whichever one you choose, you'll be making college much more affordable for your child.