It's no secret that college costs are soaring. Incoming college students and their families have come to expect an exorbitantly high price tag for tuition, which is currently the third-most-important factor in the college decision-making process. It turns out that inflation rates are a primary culprit. According to Gordon Wadsworth, author of The College Trap, "…if the cost of college tuition was $10,000 in 1986, it would now cost the same student over $21,500 if education had increased as much as the average inflation rate but instead education is $59,800 or over 2 1/2 times the inflation rate." Even though we all know that we should, most families aren't saving for college.
In fact, only two out of five families have a savings plan to pay for college, and only 27% of families used a 529 account to save for college.
However, proper financial planning and saving for college provides even more benefits than you might think. Saving broadens the list of schools that you can afford to attend, reduces debt coming out of school, and eases the anxiety around this major life transition. Additionally, those with a college savings account tend to borrow 33% less to pay for college and save 46% more than those who did not plan ahead for college costs. In this piece, we'll break down the basics of college saving and help get you started on the path to affordable higher education.
How Much Does College Cost?
One thing is certain: expensive colleges will only become more expensive in the coming years. However, there are still many factors that can affect the cost of an education from one college to the next. For example, tuition at private colleges tends to be higher than at a public school. The type of degree or program you plan to pursue and the amount of time you plan on studying also have a significant impact on college costs. Medical or nursing students, for example, are required to satisfy years of clinical experience in addition to completing extensive academic study and therefore their college tuition costs will be incredibly high. Public colleges also typically offer lower tuition and fees to in-state students, as many state institutions are funded in part by tax revenue of their local residents. As a result, they charge higher prices to non-resident students for the use of campus housing and on-site resources.
Types of College Savings Plans
If the idea of saving for college seems overwhelming, then you're not alone. One look at the cost of a four-year degree is enough for many students and their families to throw in the towel. However, many parents and families who want to plan for college are simply unaware of the savings plans available to them through federal, state, and private sources -- all of which offer the added advantage of tax benefits. In the following section, we'll explore how to identify and differentiate some of the most common and effective college savings plans.
What is a 529 Plan?
A 529 saving plan is among the most common and highest recommended forms of saving for college. This plan is specifically designed with college study in mind and is sponsored by a state or state agency. 529 saving plans are recognized by most two- and four-year colleges and universities in the U.S. and eligible foreign institutions. They are open to U.S. residents of any state who are at least 18 years old, which means contributors can range from grandparents of a future college students to the student themself. This account's earnings grow is federal-tax-deferred and are tax-free if used for qualified higher education expenses. Many states also offer tax deductions for contributions, tax-free earnings growth, and tax-free withdrawals. Contributors may choose between the 529 college savings or 529 prepaid tuition plan; the main difference is that the prepaid tuition plan has more fixed terms that may include age or grade limits and can only be used for tuition and mandatory fees.
| 529 College Savings | 529 Prepaid Tuition | |
|---|---|---|
| Age Limit | No limit | Plan may set age or grade limits. |
| Contribution Limit | Up to $70,000 (or $140,000 per married couple) per beneficiary per year without incurring gift taxes. | Fixed by terms of contract purchased. |
| Federal Tax Benefits | Earnings grow tax-deferred and are tax-free if used for qualified education expenses. | Earnings grow tax-deferred and are tax-free if used for qualified education expenses. |
| State Tax Benefits | Varies by state; some states provide tax deduction for contributions, tax-free earnings growth, and tax-free withdrawals for qualified education-related expenses. | Varies by state; some states provide tax deduction for contributions, tax-free earnings growth, and tax-free withdrawals for qualified education-related expenses. |
| Income Phase-Out | None | None |
| Penalties | Earnings taxed as ordinary income, may be subject to 10% penalty. | Earnings taxed as ordinary income, may be subject to 10% penalty. |
Coverdell ESA
A Coverdell Education Savings Account (ESA) is a trust or custodial account established exclusively for the purpose of paying qualified education expenses of a designated beneficiary. A Coverdell ESA can be opened at any U.S. bank or other IRS-approved entity. Unlike the 529 plan, a Coverdell ESA can also be used for qualifying K-12 costs. However, all contributions must be made before the beneficiary reaches 18 years old and the account must be used by the time they are 30 years old. While there is no limit to the number of Coverdell ESA accounts that can be opened for any one beneficiary, the investment limit is $2,000 per beneficiary, per year, across all accounts.
What Are UGMA and UTMA Custodial Accounts?
Uniform Gifts to Minors Accounts (UGMAs) and Uniform Transfers to Minors Accounts (UTMAs) are custodial accounts that allow minors to own securities and assets through a trust, though the terms are established by a state statute as opposed to a trust document. Through these accounts, donors can contribute to the trust and a custodian is appointed to manage the funds on behalf of the minor until they reach the age of trust determination. UGMAs are typically used to transfer stocks, bonds, mutual funds, annuities, or life insurance policies from beneficiaries to minors, while UTMAs allow for the transfer of property, fine arts, patents, royalties, and inheritance-based assets. Unlike 529 savings plans and Coverdell ESAs, UGMAs and UTMAs are general investment accounts that are not specifically designated for education. However, they are commonly used by wealthier families trying to save money for college.
Other Investment Accounts
There are other types of investment accounts that can be used for saving for college, although that is not their normal use. Roth IRAs, mutual funds, and 401Ks are some of the best known investment tools that are used for saving for retirement or playing the stock market. Some would argue that they can also be beneficial for prospective college students. Since these investment accounts are not specifically designed for higher education costs and their related tax benefits, each will have its own perks and pitfalls. Below we'll explain how you can use each of these types of accounts to start saving for college.
Roth IRA
Mutual Funds
401k
Tax Savings for College Savings Plans
In an effort to incentivize the college saving process, the IRS offers a variety of tax benefits for those participating in U.S. college savings plans like a 529 or a Coverdell ESA plan. While contributions into 529 plans are non-deductible, no taxes are due on distributions from the plan, unless the amount distributed is greater than the beneficiary's adjusted qualified education expenses. Qualifying expenses include tuition and fees, books, supplies, equipment including computer or peripherals, computer software, internet access, and possibly room and board. The same rules can be applied to Coverdell ESAs, though participants in this plan owe a 10% tax on any distributions exceeding qualified education expenses. They may also claim an education tax credit in the same year that they receive a tax-free distribution, as long as they are used for different expenses.
When Should you Start Saving for College?
It's never too early to start saving for college. If you plan on having children, you should start saving as soon as you possibly can. The main benefit to starting early is that you give your money more time to grow. If you started saving $25 per week for the first 10 years of your child's life, then you could have an investment of at least $13,000 to begin their college saving fund. This money could be put into an account like a 529 or an ESA, both of which will grow your investment over time through the magic of compounding interest. Allowing your contributions to sit undisturbed and amass for as long as possible will result in higher tax benefits and almost exponential growth for your child's future education expenses.
Give your money time to grow.
While the incentives for saving early are obvious, this does not mean that it will be possible for every family. We all know how the pressures of daily life can sometimes get in the way of our best laid plans. That said, it's never too late to start contributing what you can to a sensible savings plan. After all, any amount that you can save now is potentially money you can avoid borrowing once your child is in college. Similarly, if you're considering a college savings plan for yourself, it's simply a matter of doing your own research to find the right plan for you. Anyone looking to start saving for college should compare the tax breaks, earning potential, and limitations of 529, ESA, UGMA/UTMA, and other general investment accounts. Consult our side-by-side comparison chart below for more information.
Which College Savings Plan is Right for you?
Not all college savings plans are created equal. When searching for the right savings plan, you'll want to consider who can contribute to the account (parents, students, grandparents, or future parents) and your family's income bracket. For example, families in a higher tax bracket may not be concerned with the tax benefits of a 529 or Coverdell plan and may have a greater amount of non-liquid assets which can help them fund a college education through a custodial account. Below are some examples of the most common ways people save money for college, along with their pros and cons.
529 Savings Plan
Parents, students, grandparents, and potential parents. A good option for lower middle class families.
Pros
- Federal tax breaks
- State tax breaks
- High contribution ceilings
Cons
- Penalty for non-qualifying, non-education expenses
Coverdell ESA
Parents, students, grandparents, and potential parents. A good option for lower middle class families.
Pros
- Federal tax breaks
- Low impact on financial aid eligibility
- Beneficiary can have unlimited accounts in their name
Cons
- No state tax breaks
- Contribution amounts are limited to $2,000 per year
UGMA/UTMA Custodial Accounts
Immediate relatives or legal guardians of beneficiary. A good option for high-income families.
Pros
- High contribution ceilings
- Earning potential
- Money can be used for anything, including non-education expenses
Cons
- No federal tax breaks
- No state tax breaks
- Impacts eligibility for financial aid
- Donor has limited account control
Investment Accounts
Parents, students, grandparents, and potential parents. A good option for upper middle- to high-income families.
Pros
- High earning potential
- Money can be used for anything without penalty
- High contribution ceilings
Cons
- No federal tax breaks
- No state tax breaks
Resources
- College Savings Plans Network
- With a focus on 529 plans, CSPN offers a comprehensive guide to 529 basics, including a college cost calculator, a map of each state's 529 options, and a side-by-side comparison tool.
- Pensions and Investments
- Featuring news, data, and research specific to pensions, investments, money management consulting, and more. PIOnline.com offers an interactive ranking of the nation's largest 529 plans, as well as other insights through charts, webinars, op-ed articles, and multimedia resources.
- Sallie Mae
- As one of America's premier lending institutions, Sallie Mae offers a variety of student loan options and a wealth of tools for planning and saving for college, including a scholarship finder, the latest consumer research studies, and more.
- Fidelity
- Fidelity Investments offers consumers one of the largest collections of financial tools online, including portfolio management and trading, advice and planning for retirement, life insurance, college savings plans and more. Fidelity-managed 529 plans offer their own credit card rewards, as well as a college gifting service.
- Finra
- Finra offers a number of regulatory tools for students seeking financial aid and for other professionals who need advice about investments. The site features a college savings comparison chart, tips on how to start saving for college, student-specific savings calculators, and more.
- SavingforCollege.com
- Saving for College is a resource dedicated to providing students with comprehensive college savings and planning tools focused on 529 plans, including comparison charts and premium tools like the Pro 529 evaluator, professional articles, national rankings, and more.
- IRS.gov
- Publication 970 of the IRS manual provides students with a detailed account of all available tax benefits for education, namely for Coverdell ESA holders. The information outlines what constitutes a "qualified education expense," what current contribution limits and related restrictions are, and how to complete tax forms documenting your Coverdell ESA.
- FinAid
- This site provides a clear and comprehensive outline of UGMA and UTMA custodial accounts, including a brief explanation of how they stack up against other types of aid, such as 529 plans.
- Investopedia
- This Investopedia page breaks down all aspects of the Roth IRA, outlining who is eligible, how to establish one, when and how to make contributions, and what potential penalties and pitfalls to be aware of.
- StudentAid.gov
- The U.S. Department of Education Federal Student Aid page offers a universal source for students who want to budget for college, start a savings plan, or research other types of aid work-study opportunities, grants and scholarships, and more.