College Savings Explained: Options for Your Child’s Future

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We all want the best for our children, and in today’s world, the best comes with a hefty price tag. According to the Department of Education, the cost of a four-year public education will exceed $200,000 by 2030. This figure may leave you feeling daunted and hopeless. You might think, “My budget can’t sustain this kind of savings,” or “I don’t earn enough to make a difference. I’ll never be able to pay my child’s full tuition.” Although your worries are valid, don’t allow doubt to discourage you just yet. As we’ve learned with retirement savings, time is money, and investing early is the best way to achieve success. So, how should you save for college? Popular vehicles include:

Section 529 Savings Plan

  • What is it? Also known as a qualified tuition plan, a 529 plan refers to the section of IRS tax code, offering parents a way to save for college.
  • Pros: 529 plans are sponsored by states or individual schools and provide:
    • Tax-deferred earnings. You won’t pay taxes on contributions or earnings with a 529 plan.
    • Tax-free withdrawals. Qualified education expenses are tax exempt, allowing you to grow your investment without a bite from Uncle Sam.
    • Tax breaks. Depending on your state’s laws, 529 contributions may qualify as a deduction on your annual returns.
    • Accrued interest. Like a mutual fund, funds from a 529 plan are invested in a variety of stocks and bonds. Consequently, their earnings generally enjoy greater returns than the average savings account.
    • A 529 plan is portable, allowing you to transfer the account to different state or even to a different family member.
  • Cons: 529 plans aren’t without their limitations, including:
    • Fund restrictions. All funds from a 529 savings plan must be used for college expenses. Funds used for other purposes are subject to state and federal taxes, as well as a 10 percent penalty. This could present a problem if your child earns a scholarship or decides not to attend college.
    • Investment limitations. Although a 529 plan is invested like a mutual fund, it doesn’t enjoy the same options or flexibility. Moving funds to a more lucrative investment will accrue the same taxes and penalties as non-educational expenses.
  • Is there a contribution limit?
  • Are there income restrictions? Not usually, but check your state’s contribution rules just in case.
  • Best for: Families saving for more than one child or who are planning to send their kids to a high-priced institution.

Coverdell Education Savings Account (ESA).

  • What is it? Like a 529 savings plan, a Coverdell ESA is a government-sanctioned account that offers parents a way to save for college.
  • Pros: ESAs are full of educational funding advantages, including:
    • Tax-deferred earnings. You won’t pay taxes on contributions or earnings with an ESA plan.
    • Tax-free withdrawals. Qualified education expenses are tax exempt, allowing you to grow your investment without a bite from Uncle Sam.
    • Investment options. Unlike a 529 plan, ESAs offer greater flexibility when it comes to how and where your money is invested.
    • ESAs may be used for K-12 educational expenses in addition to college expenses.
    • An ESA is portable, allowing you to transfer the account to different states or even to a different family member.
  • Cons:
    • Fund restrictions. All funds from an ESA must be used for college expenses. Funds used for other purposes are subject to state and federal taxes, as well as a 10 percent penalty. This could present a problem if your child earns a scholarship or decides not to attend college.
    • ESA contributions are not tax-deductible.
    • Contributions must be used before your child is 30 years old or transferred to another family member.
    • ESA contributions may not exceed $2,000 per year.
  • Is there a contribution limit? Yes (see above).
  • Are there income restrictions? Parents must have an adjusted gross income less than $110,000 or $220,000 if filing joint taxes.
  • Best for: Families with other investments who wish to contribute to their child’s education or only intend to pay a portion of tuition and expenses.

Roth IRA

  • What is it? Generally used as a retirement and estate-planning vehicle, Roth IRAs are also an effective way to save for college.
  • Pros:
    • Multiple uses. Roth IRAs are not specific to college savings, allowing you to use your funds for various purposes.
    • Money not used for college can be left to children as tax-free inheritance.
    • Tax-free withdrawals. Funds from a Roth IRA may be withdrawn at any time.
    • Roth IRA contributions are tax-deductible.
    • Investment options. Like ESAs, Roth IRAs offer greater flexibility when it comes to how and where your money is invested.
  • Cons:
    • Roth IRA earnings are subject to income tax.
    • Roth IRAs require an initial investment of $2,500 to open an account.
    • Depending on your income, Roth IRA contributions may not exceed $5,500 per year.
  • Is there a contribution limit? Yes (see above).
  • Are there income restrictions? Parents must have an adjusted gross income less is $183,000 to $193,000 for married couples filing jointly. The limit for single parents is $116,000 to $131,000.
  • Best for: Families who want flexibility when it comes to paying for college, or aren’t sure whether their child will need/use college funding.

The bottom line: Paying for college is an expensive goal, one you shouldn’t ignore. Protect your finances by talking to a financial planner about the best course of action.