The cost of a college education is higher than ever, and recent trends suggest that the tuition, fees, and related expenses of going to college are likely to climb at a faster rate than inflation indefinitely into the future. If you want to make sure that your child doesn’t end up with a mountain of student loan debt, you can’t afford to wait to come up with a college savings strategy to help bridge the gap between inadequate financial aid and rising expenses.
Fortunately, there are several different ways you can save for college. By using as many of them as you can, you can come up with a balanced approach that will give you the best possible chance of getting your kids to college successfully.
1. 529 plans
One of the most popular ways to save for college is by using college savings plans, also known as 529 plans. With a 529 plan, you’re allowed to make after-tax contributions into an account that you own, naming your child as beneficiary. You can invest the money you contribute, and the income and gains in those investments don’t get taxed while the money’s in the account. As long as you eventually use the money for qualified educational expenses — like tuition and the fees that are required for students at a particular college — those investment gains become tax-free. In addition, some states add tax incentives of their own, such as deductions on your state income tax return.
These 529 plans have several advantages. They come with very high contribution limits, letting you save almost as much as you’d ever want toward your children’s education. You also have the right to switch beneficiaries, so if you have more than one child and end up having money left over after the first child is done with college, you can switch the account to go toward your other children’s education. And 529 plan assets are treated as parental assets for financial aid purposes, limiting their negative impact on financial aid eligibility. As long as you’re careful about picking the best 529 plan for your needs, these college savings plans can be extremely effective.
2. Coverdell Education Savings Accounts
Another vehicle for college savings is called the Coverdell Education Savings Account, or ESA for short. Formerly known as education IRAs, Coverdell ESAs closely resemble Roth IRAs in the way that they work. Investors make after-tax contributions to the ESA, but any subsequent earnings and gains are tax-free as long as the money is used for qualifying educational purposes.
The advantage of ESAs over 529 plans is that you get to pick nearly any investment you want in an ESA. With 529 plans, you are generally limited to certain menus of investment options, most commonly mutual funds or exchange-traded funds, and not all investors are pleased with those limitations. However, the problem with ESAs is that there’s a $2,000 annual limit on contributions, and some high-income earners aren’t allowed to make ESA contributions at all. Because of those low contribution limits, ESAs have never been as popular as 529 plan accounts for college savings.
3. Custodial accounts
Finally, you can always save directly for your child in an account in your child’s name. Typically, you’ll need to open a custodial account, with you acting as custodian of the funds and with your child listed as a beneficiary.
The advantage of a custodial account is that you can invest it however you’d like, with no limitations on the types of investments. If it turns out that you don’t need the money for educational needs, then there are no restrictions on the expenses that one can use the funds to cover.
But custodial accounts come with a couple of problems. First, when your child reaches the age of majority (typically 18 in most states), the money in a custodial account legally belongs to the child. Parents can no longer exercise control over custodial accounts beyond that point. In addition, for financial aid purposes, custodial accounts are treated as the child’s own assets, which can lead to a substantial cut in financial aid eligibility. Because of the potential for loss of control, parents typically limit the amount of money they put in custodial accounts.
Be smart about college
Saving for college requires smart thinking, and the sooner you plan, the better. By using some or all of these three college savings vehicles, you can improve the chances that your child will get through college debt-free and well-positioned to start a career on a financially secure footing.