Choosing The Right College Savings Account (And Other Tips To Keep Costs Down)

The costs of attending college continue to increase well above inflation, making it appear unreachable for most Americans without financial assistance. The cost varies based on whether the student is in state, out of state, at a public or private university, and the type of degree. A professional degree, such as a doctorate or J.D. (law), could easily set you back hundreds of thousands of dollars. In 10 years, according to the US Department of Education, tuition at a public university will be over $44,000 per year! So, what can you do if you still want to help your child (or children) attend college? The good news is, you have options and there are ways to save some money.

First, do not assume your child will get (any) scholarships. While there are plenty out there and you should apply for as many as possible when the time comes, it is too far in the future to assume Susie or Billy is getting a free ride. Consider it a nice bonus if it does happen.

Second, to keep costs low, you may want to consider encouraging your child to attend community college for a few years to bang out those general education courses and then transfer to a larger university to complete his/her degree. You will save thousands!

Third, the government provides grants to low income families who qualify. If you think you may be eligible, this will reduce your out of pocket costs significantly.

Even if there is a scholarship or two, some government assistance, and your child attends community college in the first 2 years, you may still have some out of pocket costs. So, in what type of account should you save? Keep in mind, saving for college should not supersede saving for your own retirement. Worst case, your child can apply for student loans, but there are no loans for retirement. That being said, let’s start saving!

1. 529 Plans - Probably the most popular account used for college savings due to its tax benefits and high contribution limits. In 2020, you are able to contribute $15,000 per child without triggering gift taxes. You choose how the money is invested, it grows tax free, and can be withdrawn tax free to pay eligible expenses, including tuition, fees, books, and even room and board. Some states also offer a tax credit on your contributions. If your child does not attend college, you are able to change the beneficiary (with some limitations). The downsides? You pay taxes and are assessed a 10% penalty on the earnings of any money you withdraw that is considered non-qualified. Also, the fees can be high. Shop around. You do not need to get a plan from the state in which you live. On a side note, up to $10,000 per year can now be used towards K-12 tuition.

2. Coverdell Education Savings Accounts (ESA) or Education IRA - This is another account specifically designed for education expenses, including K-12. Like the 529, the money grows tax free and can be withdrawn tax free if used for specific education expenses. The downsides? The contribution limit is only $2,000 per year per child (and has been for a long time), there are income limitations to contribute, and if the account is not distributed by the time the child turns 30, the remaining amount is subject to tax and penalty.

3. UTMA or UGMA (terminology varies by state) - Unlike the 529 and ESA, a UTMA/UGMA is not earmarked for college or education expenses, but can be because it is set up for the benefit of the child. The account can be withdrawn at any time as long as the expenses are used for the minor. This account is like a taxable or brokerage account so you are able to select from a variety of investment options. You are also able to contribute as much as you like (caveat: see gift tax exclusion). The downsides? Like any brokerage, you pay taxes on the dividends or capital gains each year. When transferred to the child at age of majority (varies from 18-21), the funds can be used for anything. Yes, anything! So, if Susie wants to use the money for a new BMW, she absolutely can.

4. Roth IRA - Yes, you read that correctly. A Roth IRA is designed for retirement savings, but there are features of the Roth that can lend itself to college savings. And to be clear, this is only if you have other funds earmarked for retirement and you aren’t sure whether your child will attend college (the money is in your name so you keep it). A Roth IRA can be invested in various ways, grows tax free, and the contributions can be withdrawn tax and penalty free at any time. Earnings can be withdrawn tax and penalty free for any reason if the account is held for 5 years and the owner is age 59-1/2 or older. The earnings are not penalized if you use the money for college, but they are taxed if you do not meet the previous criteria. The downsides? The contributions limits are relatively low (In 2020, $6,000 or $7,000 per year if over age 50) and there are income limits to contributing to a Roth IRA.

5. High Interest Savings Account - You can contribute as much as you want and the principal stays steady. The downsides? You are taxed on the interest and in a low interest rate environment, you would need to contribute much more to make up for the lack of growth. This could be a viable option if your child is older and you only have a few years left to save.

These are the primary accounts used for college savings and should help you begin to narrow your choices. However, it is by no means an exhaustive list on the rules of each plan. For instance, some accounts titled to the child or custodial parent are counted as income when applying for financial aid and could hurt your chances of getting free money. Please consult with a tax or financial advisor for more information and to find out which plan(s) might work best for your situation.