Matt Becker details the pros and cons of different ways to save for your little one’s future. Are you currently saving for college? Which methods work for you?
The very first financial question for many new parents is how to save for their child’s education. And while the 529 plan has become the default answer for college savings (with good reason), the truth is there are a number of options and the right choice for you will depend on your specific goals.
We’ll cover some of the other ways you can save for college, from a dedicated education savings account like a Coverdell ESA to a retirement account like a Roth IRA. We’ll detail the pros and cons of each so that you can make an informed decision about what works best for your family.
A Coverdell ESA is a lot like a 529 plan, with a few key differences.
Like a 529 plan, money inside a Coverdell ESA grows tax-deferred and can be withdrawn tax-free for education expenses. The big advantage of a Coverdell ESA is that the money can be used to cover education expenses from kindergarten onward, while a 529 plan is limited to higher education expenses (college and beyond). This could be a useful feature if you would like to send your child to a private school or pay for academic tutoring.
But there are some drawbacks to a Coverdell ESA. There’s no state income tax deduction (not an advantage with 529 plans in some states as well), and contributions are limited to $2,000 per year, per child.
And unlike a 529 plan, there are some income limitations that restrict who can participate. For example, a married couple will start to be phased out from making contributions once their Modified Adjusted Gross Income hits $190,000.
- Money can be used for K-12 expenses.
- More investment options than a 529 plan.
- Contributions are limited to $2,000 per year per child.
- Income phase-outs will prevent some parents from using it.
- No state income tax deduction.
A Roth IRA is actually a retirement account that promises tax-free withdrawals once you reach the age of 59 1/2. But it has three key features that can make it a pretty good college savings account as well. First, you can withdraw up to the amount you have contributed at any time, for any reason, without taxes or penalties (with some exceptions). So that money could be used for college expenses, or potentially any other goal.
Second, earnings you withdraw from a Roth IRA (any amount above what you have contributed) before age 59 1/2 are typically subject to both taxes AND a 10 percent penalty. But if the money is used for qualified higher education expenses like college tuition, the 10 percent penalty is excused.
Third, if you don’t end up needing the money for college, you can simply keep it in the Roth IRA and use it tax-free for retirement. You can’t do that with a 529 plan.
The big downside to this approach is simply that contributions to a Roth IRA are currently limited to $5,500 per year, so any amount you use for college means you have that much less available for retirement.
- Tax-deferred investment growth
- More investment options than a 529
- Flexibility to use the money for retirement or college
- Withdrawals up to the amount you have contributed are both tax-free and penalty-
- Withdrawals above that amount are penalty-free if used for qualified education expenses
- Savings does not affect your financial aid eligibility
- There is a risk of sacrificing your retirement savings for college savings
- Withdrawals from one year can negatively impact your financial aid eligibility the next year
- While you can avoid the 10 percent penalty, your earnings will still be taxed
Regular Investment Account
You don’t have to save for college within a special college savings account (or a retirement account like a Roth IRA). You can open a regular investment account and put money away for college or any other savings goal, and this can often be a great option.
The big disadvantage to this approach is also the big advantage. With a regular investment account, you don’t get the tax benefits of a 529 plan, Coverdell ESA, or Roth IRA. But the lack of tax benefits also means that there is a lack of restrictions, giving you total control over how you use the money.
You might earmark this money for college today, but if your situation changes you could use it to buy a house, travel the world, start a business, or anything else that you might want to do.
- More investment options than a 529 plan
- Complete flexibility to use the money however you want
- No tax benefits
UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) accounts are custodial accounts where the money is legally transferred to the child, but someone else (often a parent) is put in charge of managing that money until the child reaches a certain age (usually 18 to 21).
The main reason these accounts exist is that minors are typically not allowed to buy things like stocks, bonds, or mutual funds. But by gifting money to your child within one of these accounts, you can invest it for them until they are old enough to take control themselves.
It’s important to understand that unlike a 529 plan, money put into these accounts cannot be taken back and you cannot change the beneficiary. Once the money is in the account, it 100 percent belongs to the child and must be used for their benefit. And on top of that, your child will take complete ownership of the account at age 18 to 21. All of which means that you may not end up having much say in how the money eventually gets used, and there is no guarantee that your child will use it to pay for college.
- More investment options than a 529 plan
- Gives your child more ownership over the money and how it’s used
- No tax benefits
- Negatively impacts eligibility for financial aid
- Can’t change the beneficiary
- Less control over how the money gets used
A savings account is a simple way to start putting money away now without locking yourself into anything. It’s easy to set up, easy to understand, comes with little risk, and allows you complete flexibility to use the money however you’d like.
The big downside is simply that you won’t get much in the way of returns. Even the best online banks are typically offering less than 1 percent interest these days. While a savings account can be great for short-term goals, you can usually find better long-term returns elsewhere.
How Will You Save for College?
As you can see, there is no one-size-fits-all approach to saving for college. With all of the different options out there, it’s really about finding the one that works best for your current situation and your long-term goals.
Are you saving for your child’s college education? If so, we’d love to hear how you’re doing it!
Matt is the founder of Mom and Dad Money, a fee-only financial planning practice dedicated to helping new parents build happy families by making money simple. His free time is spent jumping on beds and building block towers with his two awesome boys.