5 smart ways to save for college
The price of higher education is only going up. Here's how to prepare.
Of the many hopes and dreams parents have for their children, one of the most common is that they will go to college.
Stay with that cap-and-gowned vision of the future for even a few minutes, however, and the anxiety-inducing thought creeps in: How am I going to pay for it? It's not a question most families can afford to put off, given the steep-and-getting-steeper price of higher education. If costs continue to climb as they have for the past decade, in 2033 it will cost around $262,000 to cover four years of tuition and room and board at a private college; at a public university, around $134,000.
The good news is there are a lot of tools to help you start saving now. Here's a guide:
1. 529 savings plans
These plans are designed to do one thing and one thing only: Help families save for college. Like a 401(k) or IRA, 529s work by investing your contributions in stocks, bonds, and mutual funds. They are state-sponsored and — once you've done your homework and decided which to enroll in — allow for a largely hands-off method of saving. The money may be applied to most accredited colleges and graduate schools, including professional and trade schools.
The big advantage here is that earnings grow tax-free, and withdrawals won't be federally taxed as long as they're used to pay for college tuition, books, room and board, and other qualified educational expenses. Plus anyone can contribute — grandparents, aunts and uncles, kindly benefactors, and so on. There are no annual contribution limits, though there are overall aggregate limits that vary by plan; generally, 529 balances can't exceed the total expected cost of college expenses.
Many people worry that 529s will negatively affect federal financial aid eligibility, but in fact, the impact is minimal. This is because the plans aren't considered parental income but rather are categorized as a parental asset, making them far less of a factor (just 5.64 percent) when a school calculates how much a family can be expected to contribute.
When shopping for 529 savings plans, compare the terms closely; the quality of the investment options vary from one to another. Keep in mind that you're free to choose a 529 that's not operated by your home state, though you may miss out on additional tax breaks (like a deduction on state income taxes). Your choice of plan is also unlikely to restrict where your child can go to school.
2. 529 prepaid plans
State-sponsored prepaid plans are exactly that: They let you pay now for college by purchasing credits — whether for part of a year, a full year, or all four years — that can be applied later toward a state college or university. The cost is typically a little higher than current prices to offset inflation, but it still protects you against higher-than-expected jumps in tuition. Prepaid plans shift responsibility for payment when your child is actually in college to the plan sponsors; between the time of your contribution and payout, the money is pooled into long-term investments.
Prepaid plans are less available than they used to be, as many states shuttered their programs or closed enrollment after the 2008 financial crisis.
Among the red flags to consider: Many plans are only offered to state residents, and cover only the cost of in-state tuition and fees, limiting where your child can go to school. (Though some plans will pay out an equivalent amount for students heading out of state.) In addition, only a few states guarantee that they will borrow money if needed to cover their obligations.
Also in this category is the Private College 529 Plan, which is sponsored by more than 270 colleges and universities. It similarly works by letting you buy credits toward the future. The participating schools guarantee your tuition benefit, and as long as your child is accepted at one of them, he or she is good to go.
3. Coverdell Education Savings Account
Like a 529 savings plan, a Coverdell account (sometimes just called an Education Savings Account) invests your contributions in an array of stocks, bonds, and mutual funds. The earnings also grow tax free, are free from federal income tax when used for qualified expenses, and are considered a parental asset when it comes to applying for federal financial aid.
One advantage to Coverdells is their flexibility: They can be used to pay for many educational expenses, from kindergarten through graduate school. However, they are only available to families below a specified income level, and you can only contribute up to $2,000 per year, per beneficiary, lest you incur a penalty. In addition, you can only contribute to the account until the beneficiary is 18. The accounts will eventually be distributed to your child if not used for college — they can't be refunded back to yourself as with most 529s — and must be fully withdrawn by the time he or she reaches 30.
4. Roth individual retirement accounts
Yes, these are retirement accounts; heck, it's in the name. But they're governed by rules that also make them compelling vehicles for college savings. For example, if you are younger than 59 ½, you can take out money — tax-free and without incurring a 10 percent early withdrawal penalty — as long as you use it for qualified educational expenses like tuition. The hitch is that the tax-free benefit only applies to the money you contributed in the first place, not your earnings. So if you contributed $3,000 a year for the past five years, you have $15,000 that can be withdrawn tax-free. Of course, if you are 59 ½ or older, earnings can be withdrawn free of federal income tax for any purpose, provided you've had the account for at least five years.
With Roths, there are annual contribution limits to be mindful of and, depending on your income, you may not be able to use it at all. Roths are phased out for single taxpayers whose income exceeds $114,000 and for married couples at $181,000.
5. UGMAs and UTMAs
These grunting acronyms stand for The Uniform Gift to Minors Act and the Uniform Transfers to Minors Act. These custodial accounts, which predate the 1996 advent of 529s, let you save on behalf of a child; the money has only to be used for his or her benefit — a definition that encompasses more than just education and provides a lot of flexibility. It's up to you to decide how to invest the money, but usually it goes into stocks, bonds, and mutual funds. There are no contribution limits, but amounts above a certain bar will incur a gift tax. In addition, the earnings are subject to taxes.
A potential drawback is that once a child reaches adulthood — typically 18 or 21, depending on the state — he or she gains control of the assets and can use them toward anything. So if you want to be sure the money is earmarked for higher education, think twice before choosing this route. Also, when it comes to determining financial aid eligibility, these accounts count as the child's assets, which will work heavily against him.