College Savings is an important financial goal for most families. Given the increasing costs for higher education, BonNor says it is pertinent that parents or guardians begin to plan and select the most appropriate savings instrument in order to meet those future needs. Here is an overview of different college savings plans, their pros and cons so you can decide what works best for your family.
The Importance of College Savings Plans
Increasing College Tuition Costs
For years now, the cost of college education has been on an increase. For the 2023-2024 school year, the costs are as follows:
- In-state public college: $10,560 according to the College Board.
- Out-of-state public college: $27,020 according to the College Board.
- Private colleges: Approximately $39,000, excluding room and board, books, and other additional costs.
Importance of Early Savings
- Compounding Power: The sooner you invest for college, the longer your money has to grow.
- Reduce Student Loans: Early savings reduce the likelihood of needing student loans, which typically have high interest rates.
- Peace of Mind: Starting early provides a financial cushion and reduces future stress.
The Many College Savings Plans
College savings plans come in a few different flavors, which can make it hard for families to pick the best options that will help them prepare sufficiently for future college costs. There are also benefits and considerations that come with each plan. Check out the most used choices here:
1. 529 College Savings Plans
A 529 plan is a tax-advantaged savings plan created to encourage saving for future education costs. These are state-sponsored plans, sometimes by a state agency or an educational institution, to save money for college in the future. They fall under two categories: savings plans and prepaid tuition plans.
a. 529 Savings Plans
- How It Works: A 529 savings plan lets you invest in mutual funds, ETFs, or age-based portfolios. The money compounds tax-free, and qualified education expenses are also withdrawn free of taxes.
- Advantages: Tax-free benefits, diversity of investment choices available to plan holders, and high contribution limits. Can be used at any accredited college in the U.S. and some colleges abroad.
- Disadvantages: Investment risk (as value can fluctuate based on the performance of your underlying investments), possible fees, and potential penalties for non-qualified withdrawals (10% penalty plus taxes).
b. 529 Prepaid Tuition Plans
- How It Works: The 529 prepaid tuition plan lets you buy a guarantee to attend college in the future by prepaying today’s rates and redeeming them later at participating colleges (usually state schools).
- Advantages: Tuition rate locked in, less investment risk, and tax benefits.
- Cons: Restricted to certain colleges or states, no allocation for other expenses such as room and board, and non-transferable.
2. College Education Savings Accounts
A Coverdell Education Savings Account (ESA) is a tax-deferred trust or custodial account set up for the benefit of paying qualified education expenses, K-12 and college costs.
- Pros: Contributions and withdrawals are tax-free for qualified expenses, invested in a range of markets (stocks, bonds, mutual funds), can be used to pay for education beyond the cost of tuition.
- Cons: Max contribution of $2,000 per year per beneficiary; income limits for contributors; all funds must be used by age 30 or transferred to another beneficiary.
3. Custodial Accounts (UGMA/UTMA)
One option is to open a custodial account (such as UGMA and UTMA accounts) that you hold in your child’s name until they reach the age of majority.
- Advantages: Funds can be used for anything, there is no contribution limit, and there is a wide range of investment options.
- Cons: Profits over a certain level can be taxed, and the assets belong to your child, which could negatively impact financial aid. The child takes over the account at a set age (usually 18 or 21).
4. Roth IRA for College Savings
The Roth IRA is not just for retirement savings; it can also be used for college. Contributions to a Roth IRA are made with taxed dollars, and you can withdraw contributions tax-free.
- Advantages: Allows the ability to use funds for retirement or education, your contributions can be withdrawn tax-free at any time, and no penalties if used for qualified education expenses.
- Disadvantages: Contribution limits ($6,500 for those under 50 and $7,500 for people ages 50 and up in 2024), penalties (including possible taxes) on early withdrawals of earnings, income eligibility restrictions.
5. Key Differences between Coverdell ESAs and 529 Plans
- Contribution Limits: While Coverdell ESAs limit contributions substantially, you can contribute much more to 529 plans.
- Flexibility: Coverdell ESAs have a wider range of investments to choose from, while 529 plans offer age-based portfolios that adjust risk over time.
- Tax Benefits: Both grow and can be spent tax-free for eligible expenses, but a 529 plan might also get you state deductions.
- Expense Coverage: Coverdell ESAs can help pay for K-12 expenses, whereas 529 plans are usually used to cover college costs.
The Factors You Should Remember Before Choosing a College Savings Plan
The best college savings plans for you and your child depend on a variety of factors, including how much higher education will cost by the time they are enrolled. But do keep the following in mind:
1. Investment Options
Look at the types of investments each plan offers. Some plans simply hold investments in various mutual funds, while others are more restrictive.
2. Tax Benefits
Consider the tax breaks that each plan offers — whether or not it offers state-tax deductions and/or credits. Ask yourself how much these benefits really tie into your financial settings and objectives.
3. Contribution Limits
Check the contribution limits across all plans to see if they work for your savings requirements. Families who want to save more aggressively might find a plan with higher contribution limits, such as a 529 plan, more suitable.
4. Control Over Funds
Some plans (such as custodial accounts) turn the funds over directly to a beneficiary, who is usually entitled to full control once reaching age 18. Decide whether you want to control the spending yourself or give your child free rein to spend the money as they wish.
5. Flexibility and Usage
Review the flexibility in how and where funds can be used. Certain plans, such as 529s, may limit expenses to those covered by the school or other qualifying educational institutions, while others might allow for more freedom.
6. Fees and Costs
Analyze the fees and costs of each plan; there can be management fees, enrollment fees, or penalties for not using the money for qualified withdrawals. This means less money goes towards your savings after fees are taken out.
7. Impact on Financial Aid
Consider how each plan affects financial aid eligibility. For example, custodial accounts are the child’s asset and affect aid packages more than parent-owned 529 plans do.
More Ways to Save for College
Cassino points out that in addition to formal savings plans, there are other creative ways for families who want strategies to save for college.
1. Scholarships and Grants
Encourage students to apply for scholarships and grants, which do not need to be repaid and can significantly reduce the cost of college.
2. Internships and Part-Time Jobs
Applying for a part-time job or internship can help students save for college. It will not only help cover costs but also provide valuable work experience.
3. Financial Aid and Loans
Find out how to apply for federal and state financial aid programs like FAFSA (which offers grants, work-study jobs, or student loans). Limit borrowing to keep debt low.
Conclusion
There are many factors to consider when deciding on the best college savings plan for you, including tax benefits and drawbacks, flexibility depending on how your child’s life pans out, annual fees, and more. The choice between a 529 plan, Coverdell ESA, custodial account, or even a Roth IRA may have significant implications but is secondary to saving from an early age and maintaining that habit. By knowing what’s out there and planning accordingly, you’ll be giving your child a solid financial foundation for their future studies.