If you have or are planning to have children, saving money for college is one of the most important financial decisions that you will ever make. Like saving for retirement or buying your first home, saving for college is something that you won’t see an immediate payoff from. In fact, you may not reap the benefits of a college savings account for decades to come. However, saving for college will pay off and, when it does, it will pay off in a big way.
This is why it’s incredibly important to know what your options are when it comes to saving for college. Choosing the right college savings plan can be the difference between boom or bust when it’s time for your children to head off to school.
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529 Accounts — The College Savings Account
529 savings accounts are easily the most popular way to save for college. This is because a 529 account is specifically designed to help you cover the cost of an education.
What are 529 Accounts?
529 plans are so valuable because they are tax-advantaged. You won’t have to pay taxes on the money that you withdraw from your 529 account to pay for qualified educational expenses.
When it comes time to open your 529 account, you’ll be faced with two options: savings or prepaid tuition. If you open a 529 savings account, then you’ll be able to put money into various mutual funds and money market funds. This money will mature over time and, when you send the kids off the college, you’ll be able to draw from this fund to pay for education-related expenses like tuition or the cost of room and board.
Choosing pre-paid tuition allows you to purchase credits from your state that you will be able to redeem at in-state schools in the future, when your kids are ready to go to school. Given the rising cost of tuition in recent years, this may be a wise decision to avoid even higher prices in the future. However, pre-paid tuition accounts are less flexible than savings accounts, so make sure that you’re ready for any future changes in plans. If your child goes to school out-of-state or decides not to go to college, your credits will be for nothing.
Coverdell Education Savings Accounts (ESAs)
Coverdell Education Savings Accounts (or ESAs) are another form of tax-advantaged college savings. In many ways, ERAs are more flexible than 529 savings plans, but they also have their own limitations.
What are Coverdell Education Savings Accounts (ESAs)?
ESAs are different from 529 savings accounts in a few ways.
- ESAs have an annual contribution limit. You can only contribute $2,000 per beneficiary each year. For this reason, some people find it beneficial to use both an ESA and a 529 savings account, putting leftover funds above the $2,000 limit into the 529 plan.
- ESAs are open to self-direction when it comes to saving. Instead of limiting yourself to select conservative funds, you can direct where your investments go in an ESA.
- Unlike 529 plans, which can only be used for college expenses, ESAs can be used to pay for K-12 education as well. This can be very useful if you’re considering sending your children to a private school before college.
ESAs aren’t likely to give you the same quantity of funds when it comes time to withdraw and pay for education-related expenses, but for families that value self-direction when it comes to investing and would like a little more flexibility for withdrawals, ESAs are a valuable tool.
Roth IRAs
Roth IRAs are one of the most popular ways to save for retirement. However, some families are finding that Roth IRAs can be a versatile and powerful tool when it comes to saving for college.
What are Roth IRAs for College?
In addition to retirement expenses, Roth IRA funds can also be used to pay for qualified education-related expenses. These include tuition, room and board, and even books.
Roth IRAs can be a little tricky to manage when it comes to saving for college, however. While drawing from your Roth IRA can be a great way to pay for college, it can also throw your retirement plans off track if you make a miscalculation or plan to retire early. On the plus side, if college ends up costing less than you had thought or your student graduates early, you’ll still be able to devote the funds in your Roth IRA to a more comfortable retirement budget. Using a Roth IRA to save for college is all about knowing your limits and planning wisely for the future.
Traditional Savings Accounts
There’s no denying that saving for college can get complicated. Sometimes it sounds like a pretty good idea to just open a savings account at your local bank, deposit funds over time, and make a promise to yourself to use that money for college expenses.
Traditional Savings Accounts for College
Opening your own personal savings account and using the funds to pay for college is going to be a lot different from using a tax-advantaged savings account. Personal savings accounts aren’t supported by the federal government to incentivize certain behaviors, so you’re not going to be getting any tax breaks or credits when you use a personal savings account to pay for college.
However, the lack of benefits also means that the shackles are off — there are no restrictions on how you use the funds from a traditional savings account to pay for an education. This flexibility can be a very good thing when you start to factor in the hidden costs of college like transportation costs, miscellaneous fees, and late night snack runs, thanks that a 529 savings account, ESA, or Roth IRA are not going to cover.
Investment Accounts (Trusts, CDs, and Bonds)
A traditional savings account isn’t your only option if you’re looking for an unregulated way to save for college. Traditional investing options are also available to you.
Investment Accounts for College Savings
Putting your money into a conventional investment account such as a trust fund, CDs, or savings bonds is another way to save money for college expenses. These accounts may grow more quickly than a personal savings account at your bank under the right conditions. Like the personal savings account, they will also be free of any restrictions on how you spend the money towards an education. However, you will find that the tax benefits of a 529 savings account, ESA, or Roth IRA are not available to you.
So Which College Savings Plan Is Best?
Choosing the best college savings plan is a matter of looking at your own individual circumstances and weighing which plan offers the best rewards for you. Education-specific savings accounts are a powerful tool when it comes to saving for college, but they won’t offer as much flexibility as savings options that aren’t supported by the government.
It’s up to you to measure your financial outlook and determine where you can be flexible and where you’d rather have the raw power of a tax-advantaged savings account. You should also remember that diversity in college savings is not necessary a bad thing — contributing a little to a variety of savings accounts can help you get the right benefits in the right places. And remember: the more you save now, the less you or your children will end up owing on student loans.
For more tips and guides, visit our student finance learning center.
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