Saving for college: How to start
- Jan 8, 2020
- 4 min read
What we'll cover
How to get started saving for college
Different types of accounts to consider for your child's future
Why you should start saving early
While you may battle the “Someday Scaries” (a.k.a. the fear of thinking that you need to be more financially secure but not knowing how to get there), what really makes you feel overwhelmed is the thought of saving for your kid’s college education.
Fortunately, you have a lot of savings options, including accounts specifically designed for education — and knowing about them can help ease a lot of stress and give you confidence in your savings strategy.
Plus, what’s better than the possibility of your child graduating debt-free and ready to take on the real world?
Read on for some of your available options to save for college.
1. 529 Plans
The main reason 529 college savings accounts are so attractive is because the money grows tax-free and can also be withdrawn tax-free at any time — as long as it’s taken out for educational purposes. That includes tuition, books, and even room and board, if the student is enrolled at least part-time.
There are also tax benefits: Over 30 states and the District of Columbia let you deduct a portion of your contributions from your state income taxes or offer you a tax credit. While 529 contribution limits vary by state , gifts of up to $15,000 qualify for the annual gift tax exclusion.
What happens to the money if your child doesn’t go to college? Funds in a 529 plan can be transferred to a different beneficiary, such as another child or grandchild, or even yourself, if you choose to further your education and want to cover your own college expenses. And it doesn’t have to be reserved for college education — a 529 fund can be used for K–12 tuition costs, too.
The downfalls of 529 plans? High fees and a lack of flexibility. While you can enroll in a 529 plan in any state, you’re limited to the investment options available in that plan, regardless of risk, growth potential, fees, and other costs. So, if after a few years, you find a better option and want to withdraw your money and put it into a mutual fund, ETF, or a different state’s 529 plan, you’ll be hit with a non-qualified withdrawal penalty. Similarly, if you choose to spend the money on something other than education, you’ll typically be hit with that penalty, plus you’ll have to pay income tax on your earnings.
Pro tip: If you live in a state that doesn’t allow you to deduct contributions on your state taxes, think about whether the limited investment options and potentially high fees are worth the tax-free growth you’ll make in a 529 plan.
2. Coverdell education savings account (ESA)
ESAs were formally known as Education IRAs, so it’s no surprise that they’re very similar to a Roth IRA: ESA contributions are made after-tax and, like a 529, grow tax-free and can be withdrawn tax-free for qualifying expenses.
Where an ESA differs from a 529 is the contribution limit. While 529 plans have high contribution limits, ESA contributions are capped at $2,000 annually.
The positive? ESAs offer a much wider variety of investment options compared to 529s and, while $2,000 per year may not sound like much, your money still has plenty of potential to grow. If you start saving for college right away, your savings plan will have $36,000 — and that’s even before factoring in compound interest (that’s the interest you earn on your principal and your accrued interest).
ESAs are also a little more flexible than 529s in what expenses count as qualified withdrawals. Money from an ESA can be used for college expenses, as well as certain elementary and high school costs, like tutoring or those oh-so-trendy school uniforms. And, like a 529 plan, you can transfer money to another beneficiary, if your child doesn’t use all the money in her account.
There are a few drawbacks to ESAs, too. First, in order to qualify, your income can’t exceed a certain amount . Second, you can only contribute to an ESA until your child turns 18 — after that, there’s an added excise tax. Furthermore, you must use your balance before your child turns 30, or you’ll have to pay a penalty tax on what’s left in the account.
3. Custodial accounts
Looking for a less-rigid option when it comes to saving for college? Consider custodial accounts.
Both types of custodial accounts — Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) — act as savings accounts created in your child’s name, with you (or another adult) acting as the custodian.
The beauty of custodial accounts? Their flexibility. As the custodian, you can withdraw and spend the money at any time for any reason, as long as it benefits the child. Another plus: The earnings and gains are taxed at the child’s tax rate instead of yours. That’s good news because your 2-year-old is probably bringing home a lot less bacon than you, so they’ll pay a lower tax rate.
The drawbacks? As the custodian, your job is to manage the funds in the best interest of the child (or other minor). Once your child is of-age (18 or 21, depending on the state), the funds must be turned over to them to use as they wish, whether it’s for college expenses or a plane ticket to Ibiza.
Also, funds in a custodial account may affect your child’s ability to receive financial aid. The Free Application for Federal Student Aid (FAFSA) considers funds in these accounts a student asset, so the more money that’s stockpiled, the bigger hit to your child’s financial aid package.
If you want to teach your child about investing, opening a custodial brokerage account for college savings is the perfect opportunity. Not only is a custodial account a great gift, but it gives them the opportunity to have skin in the game. Look for an account with little-to-no fees and a low investment minimum, so your child can start small and watch their money grow.
4. Deposit accounts
You can also stick with a form of saving you’re likely already familiar with — Online Savings Accounts, Money Market Accounts, and Certificates of Deposit (CD) are all easy ways to save for college. Plus, there’s no contribution limits or confusing tax implications linked to withdrawals. You can also put your savings on autopilot by setting up recurring transfers, so you don’t have to think about growing those funds.
Savings accounts and money market accounts are relatively easy to access, but CDs are a good way to lock down rates for a certain period of time (although that also comes with an early-withdrawal penalty). Try building a CD ladder as part of your college savings plan.
The “trust fund baby” stereotype might have you rolling your eyes at this option, but there’s no denying that trusts can be a good way to save for your child’s future, if you have the resources.
One of the most appealing aspects of setting up a trust account is that it helps with your estate planning. This means that if you open a trust meant for education, legal restrictions prevent your child from blowing it on a fancy new car or wild vacation.
The biggest negative? You guessed it: cost. Establishing a trust typically requires the services of a trust attorney, which can cost thousands of dollars.
Save early, save often
While college may seem decades away for your little bundle of joy, feisty toddler, or sullen pre-teen, it’s never too soon to begin thinking about a college savings plan.
Knowing how to start saving for college can be even more scary than paying off your own student loans. But helping your child graduate from college without owing a penny isn’t impossible.
No matter which strategy you choose, the key is to start your education savings plan early. The more time your money can grow, the more you can accumulate without having to do a thing — and the more energy you can dedicate toward running around the backyard with Jimmy and building Lego cities with Becky.
• How are you saving for your children's education?
• What is your savings strategy?
• What is your biggest struggle when it comes to college savings?
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