When it comes to saving money for college, you don't need a specialized savings vehicle. You can choose to simply put money in a savings account or use your brokerage account to invest for college, to name just a couple of examples.
On the other hand, there are some savings methods that are specifically designed for college, as well as some outside-the-box ways that you might want to consider. This isn't an exhaustive list, but the main college savings vehicles include:
- 529 savings plans
- 529 prepaid tuition plans
- Coverdell Education Savings Accounts (Coverdell ESAs)
- Individual retirement accounts, or IRAs -- especially Roth IRAs
- UGMA/UTMA custodial accounts
By preparing early and putting money aside for college, your child is less likely to need to rely on student loans for their education. With that in mind, let's look at each of these options a little more closely and explore the pros and cons of each one.
529 savings plans
The term “529” is generally used to refer to 529 savings plans, but technically there are two varieties of 529 -- savings plans and prepaid tuition plans. A 529 savings plan is more common and is designed to allow parents and other relatives to set money aside and invest it for college expenses in a tax-advantaged manner.
The simplified version of how a 529 savings plan works is that you contribute money, select your investment option(s), and watch the account's value build up over time as you make additional contributions and your investment returns compound.
529 savings plans are offered by the states, and while you don't necessarily need to choose the plan offered by your state, it might be in your best interest to do so, as we'll get into in the next section.
Tax structure of 529 savings plans
A 529 savings plan has a beneficial tax structure for college savers and works in a similar fashion to a Roth IRA.
Money you contribute to a 529 is made on an after-tax basis. That means that your contributions are not deductible on your federal tax return in the year you make them. However, since 529 plans are run by individual states, you might be able to deduct your contributions on your state tax return. That's why if you live in a state that has an income tax, your own state's plan is often the best choice.
Once you've made your contributions, you don't have to worry about taxes on dividends or capital gains on a year-to-year basis, so your investments compound on a tax-deferred basis. As long as you use your eventual withdrawal toward qualified educational expenses (more on that later), your withdrawals will also be 100% tax-free, no matter how much your investments have grown.
How much can you contribute to a 529 savings plan?
There's a maximum amount of money you can contribute to a 529 savings plan, but it's rarely a limiting factor. In short, these accounts tend to have high limits -- for example, my state's (South Carolina) 529 savings plan stops accepting new contributions once a beneficiary has $500,000 in the plan. Most other states have comparable limits.
The maximum contribution limit to 529 savings plans can vary, but is generally enough to fund the cost of four years of education (and usually much more) at any educational institution in the United States.
What are qualified educational expenses for a 529?
I mentioned earlier that 529 withdrawals are tax-free if the money is used for qualified educational expenses. This includes, but is not necessarily limited to:
- Tuition and required fees
- Required textbooks
- School supplies
- Housing (on- or off-campus, but off-campus housing is subject to certain cost limitations)
- Meal plans
- Tuition to K–12 schools, up to a maximum of $10,000 per year
It's also important to mention that qualified educational expenses do not include health insurance premiums while in school, any transportation expenses, college application fees, or testing fees.
Some of the other college savings methods we'll discuss also restrict expenditures to qualified expenses, and they generally conform to this same definition, so it's worth knowing the basics.
Potential drawbacks of a 529 savings plan
There's no such thing as a perfect way to save for college, and the 529 savings plan certainly isn't an exception.
For one thing, withdrawals are tax-free when used for qualified expenses, but if you don't use them for educational expenses, it can be expensive. Not only can you be taxed on the earnings portion of your non-qualified withdrawal (your investment profits), but the earnings would also be subject to a 10% penalty from the IRS. You have the option to transfer the account balance to another beneficiary if your child doesn't use it, but 529 savings plans are best used for funds that you're specifically committing to spend on education expenses at some point.
529 prepaid tuition plans
We're not going to spend a ton of time discussing 529 prepaid tuition plans for one big reason: They aren't available in most of the United States.
A 529 prepaid tuition plan essentially allows you to pay for college tuition in advance at the current rates. The idea here is twofold -- first, it's easier to pay for four years of college when you stretch it out over as long as 18 years, and second, the current in-state tuition rate is likely to be far lower than it will be when your child reaches college age, especially if they're young now.
These can be a good fit for people who want a guaranteed return (as opposed to returns dependent on investment performance), and whose children are likely to attend in-state public universities. They are generally not ideal if your child goes out-of-state, as they often will not pay the full amount of tuition for schools outside of the plan.
Arguably the biggest drawback is that you typically have to be a resident of the state where the prepaid tuition plan is based. And not all states offer prepaid tuition plans. Currently, 18 states have prepaid plans, only 11 of these are accepting new applicants, and all but two have residency requirements.
A Coverdell ESA is similar to a 529 savings plan in several key ways. For starters, the general tax structure is the same. Contributions are not tax-deductible, but investments grow tax-deferred in the account and qualifying withdrawals are tax-free. And the acceptable uses of funds and penalty for unqualified withdrawals on this college savings plan are essentially the same.
There are a few big differences, however. Coverdell ESAs are not state-run and are offered through major brokerage firms. So you can't get a state tax deduction for your contributions.
Perhaps the biggest difference is the contribution limit. Coverdell contributions are limited to just $2,000 per year, per beneficiary, so even if you start when your kids are very young, this might not be enough all by itself.
Additionally, there's an age limit when it comes to using the money. Funds in a Coverdell ESA must be used for qualified education costs by the time the beneficiary is 30 or be given to another relative. 529 savings plans have no such restriction.
Coverdells are also more flexible when it comes to investment choices. A 529 savings plan is set up similarly to a 401(k) in this respect -- you select your investment from a small list of funds and portfolios. On the other hand, with a Coverdell, you can invest in virtually any stocks, bonds, or mutual funds you want. So if you want to invest some of your kids' college funds in say, Apple stock, a Coverdell can allow you to do it.
For most people, the downsides of a Coverdell outweigh the benefits. After all, the state tax benefits and high contribution limits of a 529 savings plan can be very attractive. They are best-suited to savers who want the flexibility to invest in virtually any securities they want.
Individual retirement account (IRA)
An individual retirement account, or IRA is generally thought of as a retirement savings vehicle, but in many cases it can be equally useful when it comes to college savings. This is especially true of Roth IRAs, which have the same basic tax structure as both 529 savings plans and Coverdell ESAs.
Here's why: There's a special provision in the IRA rules that allows for withdrawals to pay for college expenses, regardless of the account owner's age. And unlike the 529 or Coverdell options, if your child doesn't end up needing the money, you can simply save it for your own retirement. Or, in the case of a Roth IRA, you are free to withdraw your original contributions (but not any investment profits) at any time, and for any reason.
One potential downside is the contribution limit, which falls between the Coverdell and 529. The annual limits are set by the IRS each year, but for 2019 and 2020, the maximum account owners can contribute is $6,000, or $7,000 if they're 50 or older.
It's also worth mentioning that IRAs are income-restricted, meaning that if you earn too much money, you might be ineligible to contribute to a Roth IRA or take a tax deduction for traditional IRA contributions. The income limitations and a potential workaround if you earn too much in 2020 are discussed in this guide to the annual IRA income limits.
UGMA/UTMA Custodial Accounts
UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) accounts are custodial brokerage accounts designed to let adults make financial gifts to minors while maintaining control of the account until the beneficiary reaches a designated age. Until the account beneficiary reaches the specified age (typically 18 or 21), the custodian (which can be you as the parent) is able to authorize withdrawals for the child on their behalf.
These accounts have no contribution limits, but large gifts may have estate tax implications for high-net-worth parents.
One benefit (or potential drawback) to using one of these accounts to save for college is that the money can be used for any purpose once your child has access to it. On the positive side, this means that if your child doesn't need all of the money for college, they could use it toward the purchase of a first car or home, to help pay for their wedding, or for virtually any other expense you might eventually want to help them with.
On the other hand, this means that they don't necessarily have to use the money to pay for school at all -- even if that's what they need it for and it's what you want them to do. Once they reach the age of maturity specified by the account, they can do with the money as they please, they don't have to listen to you.
A potential drawback of using UGMA/UTMA accounts is that once you contribute money to the account, it becomes legal property of the beneficiary. In contrast, money in a 529 savings plan or Coverdell still belongs to the person who opened the account.
This can hurt the student when it comes time to apply for financial aid, as the expected contribution formula gives student assets a heavier weight than parent-owned assets. Similarly, UGMA and UTMA accounts are not tax-advantaged, and since the money is the property of the child, any interest, dividends, or capital gains may need to be reported on the child's tax return. Ask a tax advisor if this applies to you.
Which is best for you?
There's no college savings plan that's perfect for everyone -- that's why all of these different options exist. For example, a 529 savings plan might not be the best choice for parents who aren't sure if their kids will end up needing money for school.
The bottom line is that it's important to weigh the advantages and drawbacks of each type of account in order to determine which is the best fit for you. And keep in mind that you don't necessarily need to settle on just one -- I use a combination of a 529 savings plan and a Roth IRA for my kids. If you find a combination that's tailored to your needs, it can help you get all the features that are important to you.