If you’re a parent, the start of a new school year may have you considering how much you’re able to set aside for your child’s college fund.
Average annual tuition in the U.S. is $38,185 for private college and $10,338 for public college.1 And those numbers may rise by 2%–3% in the coming school year.2 So, the sooner you start saving to support your child’s future, the better.
Fortunately, investment accounts, such as 529 plans and Coverdell education savings accounts, are designed to help parents maximize their college savings efforts. In addition, there are several alternative approaches parents can take to put away money for their children’s education. Here’s a look at the different options you can choose from:
529 Plans
Qualified tuition plans, or 529 plans, are tax-advantaged savings plans sponsored by government agencies or educational institutions. They are among the most popular college savings funds, allowing parents (or friends and relatives) to contribute to a child’s future college tuition expenses.
There are no annual contribution limits to 529s; however, they are considered gifts for federal tax purposes, and tax-free individual gifts cap at $16,000 annually in 2022. Contributions are not deductible at the federal level. However, they do grow tax-free, and withdrawals are not taxed as long they are used to pay for qualifying educational expenses, such as tuition, room and board, and meal plans. In most states, contributions to and disbursements from 529s are exempt from state income tax.
Plan options and tax benefits vary from state to state, and you can use most states’ 529 plans, so shop around for the best options for you.
Coverdell Education Savings Accounts
Coverdell Education Savings Accounts (ESAs) offer similar advantages to 529 plans. Contributions are not tax-deductible, and there is an annual contribution limit of $2,000 per beneficiary. These funds grow tax-free and can be used to cover qualifying education expenses.
In some cases, Coverdell ESAs provide greater flexibility than 529s. While 529 plans can be used to cover $10,000 a year in K–12 tuition, Coverdell ESAs can be used to cover other K–12 expenses as well.
However, there are limitations. Coverdell ESAs must be used by the time the beneficiary turns 30, or tax penalties may apply. They are also only available to families with a modified adjusted gross income of less than $220,000.
Alternative Options
You don’t have to save for college expenses in a plan that was specifically designed for it. The following investment accounts are sometimes used to save for college expenses. Each option may impact eligibility for financial aid, so consult a financial aid advisor before investing.
Custodial accounts known as Uniform Gift to Minors Act and Uniform Transfers to Minors Act (UGMAs and UTMAs) have few restrictions on the types of assets they can hold, and funds are disbursed to the beneficiary when they reach the legal age of majority. These vehicles are often taxed at a lower rate because the beneficiary is a child. Since there are no spending restrictions on UGMAs or UTMAs, the beneficiary is not bound to spend the money on education expenses.
Parents might also opt to invest college funds in a Roth IRA. Typically used as a retirement fund, a Roth IRA can also be used as an investment vehicle for college as well. Withdrawals made to pay for qualified education expenses are exempt from early withdrawal penalties.
Some families may opt to invest college funds in a permanent life insurance plan. With this plan, a portion of each premium is funneled into a tax-deferred savings account. Funds can be accessed at any time and spent without restrictions, offering beneficiaries a great deal of flexibility. However, this option can come with costly fees and other risks, and may not be appropriate for every investor.
Your financial advisor can help you choose the most effective option for your family. Start saving for your child’s college as soon as you can to take advantage of the power of compounding returns and continue to make regular contributions as your child grows.