If you're overwhelmed by the thought of saving for college for your child, you're not alone. The good news is you have a lot of strategies at your disposal, including accounts specifically designed for education. Learning the alternatives can ease stress and give you confidence in your savings strategy.
The cost of college
The cost of college continues to rise, and U.S. students were $1.75 trillion in student loan debt in 2022, according to the Federal Reserve. That underscores how important it is to start saving for college as early as you can.
Even if you can't pay the whole cost of tuition and college expenses with your savings, every little bit helps. (Remember, they can still get scholarships, grants and other aid.)
Here are a few methods to start saving for college — and you don't have to stick to just one.
1. 529 Plans
A 529 plan is a state-by-state college savings method where money grows tax-free, and you can take it out anytime for educational purposes. That includes tuition, books, and even room and board if enrolled at least part-time.
529s have less flexibility than other types of accounts. While you can enroll in a 529 plan in any state, you're limited to the investment choices available in that plan, regardless of risk, growth potential, fees and other costs.
In addition, you'll encounter a nonqualified withdrawal penalty fee (plus income tax on earnings) if you ever want to withdraw your money for any ineligible expenses.
2. Coverdell education savings account (ESA)
Education savings account (ESA) contributions are made after-tax and, like a 529, grow tax-free. You can also withdraw money tax-free for qualifying expenses.
ESA contributions are capped at $2,000 annually. While $2,000 may sound paltry, if you start saving for college right away, your savings plan will have $20,000 after 10 years — and that's before compound interest (the interest earned on interest).
However, your income can't exceed a certain amount. You can only contribute to an ESA until your child turns 18 — after that, you pay an added excise tax. You must use your balance before your child turns 30, or you pay a penalty tax on your account balance.
3. Custodial accounts
Looking for a less rigid method to save for college? Consider custodial accounts, either a Uniform Transfer to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA), which act as savings or brokerage accounts created in your child's name, with you (or another adult) acting as the custodian. Opening a custodial account is as simple as selecting "custodial" as the account type during the opening process with either Ally Invest or Ally Bank.
As the custodian, you can withdraw and spend the money for any reason benefiting your child. The earnings and gains are taxed at the child's tax rate instead of yours. (Your two-year-old is probably bringing home less bacon than you, so they pay a lower tax rate.)
Once your child is of-age (18 or 21, depending on your state), you must turn over the funds to them to use as they wish, whether for college expenses or a plane ticket to Ibiza.
4. Deposit accounts
You can also stick with a form of saving you know — savings or money market accounts and Certificates of Deposit (CD). Plus, there are no contribution limits or tax implications linked to withdrawals.
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 downside with trusts is cost. Establishing a trust requires the services of a trust attorney, which can cost thousands of dollars.
Apply for scholarships and grants
Scholarships and grants come from a wide variety of sources, including the college where your child applies, local organizations (such as Kiwanis or Rotary Clubs) or your state or federal government.
How to maximize financial aid
Consider filing the Free Application for Federal Student Aid (FAFSA) to maximize scholarships, grants, work-study (where your child works and earn a paycheck at school) and federal student loans. Federal student loans (and work-study, for that matter) come from the federal government.
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 chance it has to accumulate.