If you’re like 9 out of 10 American parents, you want your child to attend college, and chances are you want to provide him or her with more money to pay for college than you got from your parents. But making a good dent in your kid’s college education expenses is a tall order today — the average one-year cost (including living expenses and books) for an undergraduate student attending a four-year private college is a whopping $42,429.

Here’s the good news: There are special college savings plans available to help whatever you can set aside grow into substantial savings. This guide is intended to help financial supporters of tomorrow’s college students determine the best way to save money for college expenses. We’ll highlight the advantages of various college savings plans and differences between each savings option

College Savings Plans at a Glance

Evaluating each college savings plan can identify the best fit for your family’s needs. General topics of consideration include income level, number of children, savings amount, career trajectory and time.

This guide examines six types of college saving vehicles: 529 prepaid tuition plans, 529 college savings plans, Coverdell Education Savings Accounts, Roth individual retirement accounts, Uniform Gifts to Minors Act/Uniform Transfers to Minors Act custodial accounts and U.S. savings bonds.

All six plans offer tax advantages by allowing the deferment of federal or state income tax. Coverdell ESAs and 529 plans have minimal effect on a student’s eligibility for financial aid. The 529 prepaid tuition plan allows parents to “lock-in” tuition costs at today’s prices. Roth IRAs and UGMA/UTMA custodial accounts provide the most flexibility in how funds are used without losing their tax benefits. Some plans, such as the Education Savings Bond Program (U.S. savings bond), phase out tax benefits through income-eligibility requirements.

Find the defining features of the six most common college savings plans below.

529 Prepaid Tuition Plans

Description A low-risk, tax-advantaged plan. Payments purchase “units” or “credits” for future use at participating colleges or universities, essentially prepaying tuition fees. Typically sponsored by state governments requiring the account owner or beneficiary to be a state resident.
Who can Open and Control Account? A resident of the state can open and maintain control. Some plans require a minimum residency period or impose an age requirement (such as 18) on the account owner.
Cost of Opening Account Fees vary; typical costs include enrollment and administrative fees.
Contribution Limit Varies between plans, but most have lifetime contribution limits of $300,000 or more.
Can Named Beneficiary Be Changed? Yes, most allow a change to the beneficiary’s brother or sister who is within a specified age range.
Beneficiary Age Limit Most plans specify age or grade limit.
College Expenses Covered Most plans limit to tuition and mandatory fees. Some include room and board or other qualified expenses.
Federal Tax Advantages Earnings are not subject to federal income tax. Qualified withdrawals do not incur income tax.
State Tax Advantages
  • Earnings and qualified withdrawals are not subject to income tax in most states.

  • A few states permit deductions for contributions.

  • State may offer matching grants.

Age by which Funds Must Be Used Varies, but generally 30.
Penalty for Non-Qualified Withdrawals Earnings become subject to income tax and a 10 percent federal tax penalty. Usually the account owner, not beneficiary, pays the tax.
Who Should/Shouldn’t Consider this Plan
  • A good student attending a state school.

  • No control over how the funds are invested. Contributions are pooled together with those of other plan investors, not in individual investment accounts.

  • Good for financial aid applicants because the account is considered a parental asset, which has minimal impact on the calculation of Expected Family Contribution (EFC).

  • Plans are usually guaranteed by the state.

529 College Savings Plans

Description Tax-advantaged plan allows owners to create individual investment accounts. Withdrawals cover expenses at any college accredited by the U.S. Department of Education. Investment options include age-based portfolios that shift toward more conservative investments as the beneficiary nears college age.
Who can Open and Control Account?

Varies by plan.

  • Some nonresidents may be limited to purchasing state plans through financial brokers.

  • Some plans impose age requirement on the account owner.

  • Citizenship or residency requirements are typical.

Cost of Opening Account Varies by plan. Typical fees include enrollment, annual maintenance and asset-management fees. Some may waive or reduce fees for state residents, accounts with large balances or automatic contributions. For broker-sold plans, also called advisor-sold, account holders incur a “load” or sales fee.
Contribution Limit Most have lifetime contribution limits of $300,000 or more.
Can Named Beneficiary Be Changed? Yes, but to avoid penalties and tax, you must change to another family member of the original beneficiary.
Beneficiary Age Limit None.
College Expenses Covered Covers “qualified higher education expenses,” which include tuition, room and board, mandatory fees, books, and computers (if required).
Federal Tax Advantages Earnings are not subject to federal income tax.
State Tax Advantages
  • Earnings are not subject to income tax in most states.

  • A few states allow deductions for contributions.

  • Many states offer matching grants for participating in your state’s plan.

Age by which Funds Must Be Used Generally no age limit on when withdrawals must be made.
Penalty for Non-Qualified Withdrawals Earnings become subject to income tax and a 10 percent federal tax penalty. Usually the account owner, not beneficiary, pays the tax.
Who Should/Shouldn’t Consider this Plan
  • Good for students who are unsure of college plans.

  • Good for financial aid applicants because the account is considered a parental asset, which has a minimal impact on the calculation of EFC.

  • Not good for the risk-averse, as there is no state guarantee or federal insurance.

  • No option to choose your own investments.

Coverdell ESAs

Description Trusts, or custodial accounts, allow account holders to contribute money for the educational expenses of the beneficiary. Contributions are permanent gifts. Qualified expenses include not only college expenses, but also elementary and secondary school expenses.
Who can Open and Control Account? An adult meeting the income-eligibility limits may open and control the account for the beneficiary. Degree of control will change over time, with complete control passing to the beneficiary when he turns 30.
Cost of Opening Account Plan costs vary by provider.
Contribution Limit $2,000 annually, as long as the beneficiary remains a minor (unless the beneficiary is a special needs child). Allowable contribution amounts phase out as adjusted gross income rises.
Can Named Beneficiary Be Changed? Yes, provided new beneficiary is under 30 and a member of the original beneficiary’s family.
Beneficiary Age Limit Under 18 at the time the account is created, unless the beneficiary is a special needs child.
College Expenses Covered Qualified expenses cover college, elementary and secondary school costs including tuition and fees, books, supplies, equipment, and room and board. Elementary and secondary school expenses can also include costs such as tutoring, uniforms, transportation and special needs services.
Federal Tax Advantages Qualified withdrawals are income tax-free.
State Tax Advantages Benefits vary by state.
Age by which Funds Must Be Used 30, at which time unused funds must be disbursed within 30 days to the beneficiary, with exception for a special needs child.
Penalty for Non-Qualified Withdrawals A 10 percent federal penalty and income tax on the beneficiary for the earnings portion of the withdrawal. May also trigger state penalty on earnings.
Who Should/Shouldn’t Consider this Plan
  • Not good for long-term control.

  • Good for investment flexibility.

  • Good for financial aid applicants because the account is a parental asset, which has a minimal impact on EFC.

Roth IRAs

Description An individual retirement plan that allows you to apply already taxed income for any use in retirement, including the payment of another individual’s college expenses. Withdrawals during retirement are tax-free.
Who can Open and Control Account? Any adult whose earned income is under a specified income level.
Cost of Opening Account Varies by plan, but usually minimal, with low or no annual fee. Fees usually apply for trades, stock and ETF commissions.
Contribution Limit
  • $5,500/year, if under 50.
  • $6,500/year, if 50 or older.
Can Named Beneficiary Be Changed? Yes, with the appropriate amendment.
Beneficiary Age Limit None.
College Expenses Covered Distributions can be used for qualified education expenses, including tuition, fees, books, supplies, and room and board, provided the student is enrolled at least half-time in a degree program.
Federal Tax Advantages Tax-free qualified distributions and investment earnings.
State Tax Advantages In most states, earnings are not subject to tax. Many states offer matching grants for participating in a plan sponsored by the state. A few states allow residents to deduct contributions from state income tax returns.
Age by which Funds Must Be Used No requirement.
Penalty for Non-Qualified Withdrawals
  • No penalties or taxes are incurred if the account owner is over 59 ½ and has had the account for a minimum of five years. Use of funds is unlimited.

  • Income tax is applied to withdrawals taken before age 59 ½ or taken from an account less than five years old to pay for qualified education expenses. You are not required to pay the 10 percent early distribution penalty.

Who Should/Shouldn’t Consider this Plan
  • Good for financial aid applicants. Roth IRAs aren’t included in assets in determining EFC.

  • Good for flexibility in fund use. Funds can be used for other uses besides higher education expenses and still retain tax benefits.

  • Good for investment flexibility in the range and types of underlying investments held.

  • Good for early savers or someone who expects to fall within a higher tax rate bracket as time progresses.

UGMA/UTMA Custodial Accounts

Description A custodial account opened through a bank or brokerage firm that is created in a child’s name. Funds are used to pay for any expense, including college, provided it is for the child’s benefit.
Who can Open and Control Account? Any adult, naming a minor child as the beneficiary. The adult custodian controls the account, but the child gains full control of the account upon the age of majority, which is 21 in most states.
Cost of Opening Account Varies. A typical minimum opening balance is $2,500.
Contribution Limit None.
Can Named Beneficiary Be Changed? No.
Beneficiary Age Limit Must be a minor.
College Expenses Covered Account funds can be used for any purpose, provided it is for the child’s benefit.
Federal Tax Advantages
  • First $1,050 of investment earnings exempt from income tax.
  • Second $1,050 taxed at beneficiary’s tax rate.
  • Remainder of investment earnings taxed at parents’ tax rate.
State Tax Advantages None.
Age by which Funds Must Be Used No requirement.
Penalty for Non-Qualified Withdrawals No penalty. Withdrawals can be made at any time and used for noncollege expenses as long as it’s for child’s benefit.
Who Should/Shouldn’t Consider this Plan
  • Not good for financial aid applicants because the account is considered the child’s asset, which weighs more heavily in calculating EFC on financial aid applications.

  • Not good for parents who want long-term control of the account. Contributions are permanent gifts to your child, so your child gains full control and access to account funds upon majority.

  • Good for investment flexibility for parents who want account funds invested in a wide range of investment options.

U.S. Government Bonds

Description Low-risk instrument that accrues monthly interest, which the bond holder receives upon cashing the bond. Specific U.S. government bonds, Series EE and Series I savings bonds issued after 1989, are eligible for the Education Savings Program. A fixed rate of return and tax-saving advantages are earned for higher education expenses.
Who can Open and Control Account? Adults who are at least 24 years of age. Owners retain control throughout of the account.
Cost of Opening Account The face value of the bond.
Contribution Limit Not applicable.
Can Named Beneficiary Be Changed? Yes.
Beneficiary Age Limit None.
College Expenses Covered
  • Qualified expenses include tuition and fees; course expenses; and sports, games or hobbies expenses if they are part of a degree or certificate program.

  • Cost of books and room and board are not qualified expenses.

  • Note: Qualified expenses must be incurred in the same year the bonds are redeemed.

Federal Tax Advantages No income tax on interest for Series EE and Series I savings bonds issued after 1989. Note: You must meet specific income, ownership and tax-filing status requirements.
State Tax Advantages Generally no income tax on interest.
Age by which Funds Must Be Used No requirement.
Penalty for Non-Qualified Withdrawals No penalty, but interest is taxed as income.
Who Should/Shouldn’t Consider this Plan
  • Not a good fit for parents who want a higher return in their college savings strategy.

  • Not suitable for parents who do not meet income-eligibility requirements.

529 Plans in Depth

The most popular college savings plans are 529 plans. Named after the Internal Revenue Code section that authorizes their creation, 529 plans are sponsored by states, state agencies and educational institutions. Two types of 529 plans exist: prepaid tuition plans and 529 college savings plans. The 529 savings and prepaid tuition plans are very different in many respects, so keep the two types separate in your mind as you compare these options.

The 529 prepaid tuition plans have been under severe pressure in recent years because tuition rates have risen at rates higher than the state plan administrators expected. As a result, some states have closed new enrollment to their prepaid tuition plans.

Tax Benefits of 529 Plans

The most attractive element of the 529 plan is the significant tax savings. Earnings in 529 plans are neither subject to federal income tax nor, in most cases, subject to state income taxes. To reap these tax benefits, you must use account withdrawals for qualified expenses. If you take a nonqualified withdrawal, tax benefits are lost and the earnings portion of the withdrawal becomes subject to both types of income tax along with a 10 percent federal tax penalty on earnings.

Tips

Make sure you consider your own state’s 529 plans. Most states offer residents income tax deductions or credits for contributions to their plans.

Caveat: Fees vary between 529 plans. Sometimes, plan fees end up exceeding the tax savings you may reap.

Ownership, Control and Flexibility of 529 Plans

As the parent who opens the 529 plan, you — not your child (beneficiary) — are the one who controls and owns the account. You dictate how much money to invest in the plan (within the plan’s contribution limits) and when to withdraw investments. Generally, prepaid tuition plans set more restrictions than 529 college savings plans.

For example, a child can attend any college or university and use his 529 college savings account. With prepaid tuition plans, withdrawals are typically limited to a smaller group of state institutions.

With both 529 plan types, the account owner maintains control over changes in the plan’s beneficiary. For example, if a child earns a scholarship, you can easily change the beneficiary to another sibling.

Caveat #1: For 529 savings plans, you have the ability to invest funds within a number of investment options, such as an age-based fund. However, you have minimal control over the plan’s underlying investments. Instead, money managers for each 529 plan handle specific investment decisions. Investment changes are limited to twice yearly or upon a change in beneficiary.

Caveat #2: For 529 prepaid tuition plans, although you maintain control and ownership of the account, these plans typically require that you use the “units” or “credits” you purchased by the time your child turns 30.

Minimal Impact on Financial Aid Eligibility

A 529 plan’s impact on eligibility for federal financial aid is negligible. In most cases, the plan is not considered the child’s asset, which is helpful when applying for financial aid through the Free Application for Federal Student Aid (FAFSA). The calculation of the EFC for financial aid eligibility incorporates 20 percent of the value of a child’s asset as opposed to a maximum 5.64 percent of the value of a parent’s asset.

Example:

If Parent’s Asset (Max. 5.64%) If Child’s asset (20%)
Amount included in EFC* Maximum $16,800 $60,000

*For 529 plan value of $300,000

Caveat: Some qualified distributions may end up counting as your child’s asset, which may hinder the chances of receiving financial aid. Qualified distributions from a plan owned by a parent are not considered your child’s untaxed income on the FAFSA because the parent asset is included in the FAFSA. However, qualified distributions from a 529 plan owned by a beneficiary’s grandparent may count as the child’s untaxed income because the plan is not reported as an asset on the FAFSA. Thus, 20 percent of any distribution your child receives from a 529 plan set up and owned by a grandparent would factor into the EFC used in calculating financial aid eligibility.

Contributions: Low Minimum and High Maximum

Minimum contribution amounts vary between plans. Some plans require a minimum opening deposit, and others waive the minimum contribution amount if you set up automatic monthly deposits to the account.

The maximum contribution to a 529 college savings plan usually equals the amount you need to cover your child’s qualified education expenses. Most state plan maximum contribution limits reflect the cost of attending the most expensive universities. Accordingly, most maximum limits typically cap at $300,000 or more.

Caveat: For prepaid tuition plans, the state’s limit generally applies to the actual contribution amount. For college savings plan, the limit applies to the account’s value, so if you’ve contributed $250,000 and the account has $50,000 in earnings, you can no longer contribute additional amounts if the contribution limit is $300,000. (See example in table below.)

How 529 Plans Apply Contribution Limits – Example

Your Total Contribution Your Total Earnings Plan’s Contribution Limit Plan’s Account Value Amount You Can Still Contribute
Prepaid
Tuition Plan
$250,000 $50,000 $300,000 $300,000 $50,000
529 College
Savings Plan
$250,000 $50,000 $300,000 $300,000 $0

Differences between 529 Prepaid Tuition Plans and 529 College Savings Plans

This chart highlights some of the more important differences between 529 prepaid tuition plans and 529 college savings plans.

529 Prepaid Tuition Plans 529 College Savings Plans
Application of Contributions

Payments are applied to the purchase of “units” or “credits” to be used in the future for tuition. You essentially prepay for college tuition.

Application of Contributions

Payments are invested in mutual funds or money market funds, and earnings from those investments are designed to add value to the account over time.

Pre-Defined Contribution Schedule

Installment payments or one lump sum determined before purchase. Amounts are based on the beneficiary’s age and number of college tuition years purchased. Most plans require accounts to be fully funded in five years.

No Contribution Schedule

Frequency and amounts depend on the contributor.

Limited Enrollment Period

Limited enrollment period, usually occurring annually, that defines when you can open an account or contribute to the account.

Open Enrollment Period

Generally open year-round.

More-Restrictive Qualified Withdrawals

Covers tuition and mandatory fees. Some plans may include other expenses.

Broader Qualified Withdrawals

Covers tuition, room and board, mandatory fees, books, and computers (if required)

Lower Investment Risk

State sponsoring plan guarantees minimum rate of return.

Higher Investment Risk

No state guarantee. Generally not federally insured. Investments are subject to market risk.

Residency Requirement

Most states limit participation to residents.

No Residency Requirement

Must participate in plan.

Required Use of Funds by Certain Age

Generally must be used by the time the beneficiary turns 30.

No Required Use of Funds by Certain Age

Generally imposes no age by which the beneficiary must use funds.

Restriction on Beneficiary Age Limit

Most restrict creation of an account to beneficiaries under a certain age or grade.

No Restriction on Beneficiary Age Limit

Most do not define a beneficiary age limit at the time of the creation of an account.

Opening a 529 Account

Opening a 529 savings plan is simple. Enlist the help of a professional, such as a financial advisor, if you prefer guidance.

Enrolling in direct state plans is also an option. Information and enrollment details, including applications, are available online for every state with 529 plans. (Wyoming and Washington are the only states not offering savings programs.) Find a list of each state’s 529 plan below.

Caveat #1: Although you may reap tax advantages from choosing a plan sponsored by the state, you are still eligible to participate in other states’ plans. Plans sponsored by Utah, New York, Virginia and Nevada were all top performers over the last ten years.

Caveat #2: Broker-sold plans, called advisor plans, require additional sales fees, sometimes called “load” fees, in addition to the enrollment fees, maintenance fees and asset-management fees. Advisor plans typically offer more investment options than direct plans, but have higher fees.

State 529 Savings Plans
Alabama CollegeCounts529 (direct) CollegeCounts 529 Advisor Plan
Alaska John Hancock Freedom 529 The University of Alaska College Savings Plan The T. Rowe Price 529 College Savings Plan
Arizona College Savings Bank’s Arizona Family College Savings Program (AFCSP) Ivy Funds InvestEd 529 Plan (advisor) Fidelity Arizona College Savings Plan (direct)
Arkansas GIFT College Investing Plan (direct) Blackrock’s iShares 529 Plan
California ScholarShare College Savings Plan (direct)  
Colorado CollegeInvest Direct Portfolio College Savings Plan CollegeInvest 529 Smart Choice College Savings Plan (direct) CollegeInvest Scholars Choice College Savings Plan (advisor) CollegeInvest Stable Value Plus College Savings Plan (direct)
Connecticut CHET 529 College Savings Program (direct) CHET Advisor 529 College Savings Plan
Delaware Delaware College Investment Plan (direct)  
District of Columbia DC College Savings Plan (direct)  
Florida Florida Prepaid College Board (prepaid tuition plan) Florida 529 Savings Plan (529 college savings plan)
Georgia Path2College 529 Plan (direct)  
Hawaii HI529 College Savings Program (direct)  
Idaho IDeal Idaho College Savings Program (direct)  
Illinois Bright Directions 529 Plan (advisor) College Illinois! Prepaid Tuition Program (prepaid tuition) Bright Start College Savings Plan (direct and advisor)
Indiana College Choice 529 Direct Savings Plan College Choice CD 529 Savings Plan (direct and advisor) College Choice Advisor 529 Savings Plan
Iowa College Savings Iowa 529 Plan (direct) IAdvisor 529 Plan
Kansas LearningQuest 529 Education Savings Program (direct and advisor) Schwab 529 College Savings Plan (direct)
Kentucky KAPT: Kentucky’s Affordable Prepaid Tuition (prepaid tuition plan closed to new enrollment) Kentucky Education Savings Plan Trust (direct)
Louisiana START Saving for College Program (direct)  
Maine NextGen College Investing Plans (direct and select)  
Maryland College Savings Plans of Maryland (prepaid tuition plan and 529 college savings plan)  
Massachusetts UFUND Massachusetts 529 Plan U.Plan Prepaid Tuition Program (prepaid tuition plan)
Michigan MI 529 Advisor Plan Michigan Education Trust (prepaid tuition plan) Michigan Education Savings Program (direct)
Minnesota Minnesota College Savings Plan (direct)  
Mississippi Mississippi Affordable College Savings Program (direct) Mississippi Prepaid Affordable College Tuition Plan (prepaid tuition plan)
Missouri MOST Missouri 529 Advisor Plan MOST Missouri 529 College Savings Plan
Montana Montana Family Education Savings Program Bank Plan (direct and advisor) Montana’s Family Education Savings Program Investment Plan (direct)
Nebraska NEST 529 College Savings Direct Plan (direct) State Farm College Savings Plan (advisor) NEST 529 College Savings Advisor Plan TD Ameritrade 529 College Savings Plan
Nevada Nevada Prepaid Tuition Program SSgA UPromise 529 (direct) The Vanguard 529 Plan (direct) Putnam 529 for America USAA 529 College Savings Plan (direct)
New Hampshire Fidelity Advisor 529 Plan Fidelity’s UNIQUE College Investing Plan (direct)
New Jersey Franklin Templeton 9 College Plans (advisor) NJBest 529 College Savings Plan (direct)
New Mexico Scholar’s Edge 529 (advisor) The Education Plan (direct)
New York New York 529 Advisor-Guided College Savings Program NY’s 529 College Savings Program (direct)
North Carolina NC 529 Plan (direct)  
North Dakota College SAVE Plan (direct)  
Ohio BlackRock’s CollegeAdvantage 529 Plan (direct) Ohio Tuition Trust Authority CollegeAdvantage 529 Plan (advisor)
Oklahoma Oklahoma 529 College Savings Plan (direct) OklahomaDream 529 (advisor)
Oregon MFS 529 Savings Plan (advisor) Oregon College Savings Plan (direct)
Pennsylvania Pennsylvania 529 College Savings Program (guaranteed savings and investment plans)  
Rhode Island CollegeBoundfund (direct and advisor)  
South Carolina FutureScholar 529 College Savings Plan (direct and advisor) South Carolina Tuition Prepayment Program (SCTPP) (prepaid tuition plan closed to new enrollment)
South Dakota CollegeAccess 529 Plan (direct and advisor)  
Tennessee TNStars College Savings 529 Program (direct)  
Texas LoneStar 529 Plan (advisor) Texas Guaranteed Tuition Plan (closed to new enrollment since 2003) Texas College Savings Plan (direct) Texas Tuition Promise Fund (prepaid tuition)
Utah Utah Educational Savings Plan (direct)  
Vermont Vermont Higher Education Investment Plan (VHEIP) (direct)  
Virginia Virginia 529 CollegeAmerica (advisor) Virginia 529 inVEST (direct) Virginia 529 CollegeWealth (direct) Virginia 529 prePAID (prepaid)
Washington Guaranteed Education Tuition (GET) (prepaid tuition plan on hold as of September 2015 due to passage of Washington’s College Affordability Act, a state law mandating cuts to the state’s tuition rates)  
West Virginia Smart529 (Direct, Select/Direct and Hartford/Advisor)  
Wisconsin Tomorrow’s Scholar 529 Plan (advisor) Edvest 529 College Savings Plan (direct)
Wyoming Wyoming closed its 529 plan in 2006 and transferred management of its 529 funds to Colorado. Colorado has since discontinued serving Wyoming residents  

* Unless noted otherwise, listed 529 plans are 529 college savings plans.

Other Types of Savings Plans

The 529 plan is not the only way to save for college. Because you aren’t restricted to using one type of plan or one account, you can use a combination of plan options.

Consider these other tax-advantaged college savings accounts.

Coverdell Education Savings Accounts

A Coverdell ESA is similar to 529 plans.

  • 1)

    You can defer tax on earnings or avoid tax payments entirely through qualified education withdrawals.

  • 2)

    The account is considered a parental asset, which is advantageous for financial aid eligibility.

  • 3)

    You can change the beneficiary without penalty, provided you designate another member within the original beneficiary’s family (and complete a rollover to a new ESA within 60 days).

In addition to college expenses, you can use ESA withdrawals to cover elementary and secondary schooling expenses. You may also customize investment holdings in the account’s underlying portfolio. Whereas 529 plans typically restrict you to stock or mutual funds or age-based portfolios, with ESAs, you choose what investments to buy and sell. You are not restricted to mutual funds, so you can tailor your investment portfolio with single stock purchases.

However, you cannot open an ESA if your income is too high. The contribution limit is drastically lower than 529 plan limits with a contribution cap of $2,000 per year. Contributions are not allowed after a child turns 18.

Read more
U.S. Government Bonds

U.S. government bonds are the most conservative college savings option. It’s unlikely you’ll see higher returns on government bonds compared to other college saving accounts, but there are specific tax advantages. Through the federal government’s Education Savings Bond Program, there is no income tax on interest earned if you use bond funds to pay for qualified education expenses. EE Series or I Series bonds issued after 1989 must be purchased in your name or your spouse’s name with your child listed as the beneficiary. Bonds are redeemed to pay for a child’s qualified education expense. However, room and board are not qualified education expenses for savings bonds. All other tax-free educational assistance your child receives must be used before savings bonds can be used for education expenses, including scholarships or fellowship grants. Unlike 529 plans, tax benefits phase out when income level rises.

Read more
UGMA/UTMA Custodial Accounts

UGMA and UTMA custodial accounts are created for the benefit of a beneficiary, who must be a minor. Unlike 529 plans, you can use withdrawals for any college expenses, as long as they benefit the child. Any money placed in the account is a permanent gift to the beneficiary and owned by the child. The child gains full control of the account upon reaching adulthood, which is 21 in most states. After age 21, the child has the right to decide to use the account for any expense.

Compared with 529 plans and Coverdell ESAs, tax savings are minimal. The federal government has instituted the Kiddie Tax rule, which puts any investment income above $2,100 in your name instead of the child’s, which means you are taxed for most of the money placed inside the account each year. This rule generally applies until the child turns 24.

If you plan to apply for financial aid, the UGMA/UTMA account is not the best choice. Because the account is considered your child’s asset, 20 percent of its value would be used in determining the EFC in financial aid eligibility. Even worse, certain investment earnings are subject to a 50 percent rate in the EFC calculation.

Read more
Roth IRAs

For grandparents who want to contribute to their grandchild’s college education, a Roth IRA may be the best choice. Unlike the restricted use of 529 plan withdrawals, withdrawals may be made from a Roth IRA at any time for any use without incurring income taxes or penalties. To avoid withdrawal penalties, you must have owned the account for a minimum of five years and must be at least 59 ½ years old. If you don’t meet these requirements but still want to make withdrawals, you must pay income tax on the withdrawal amount. However, the 10 percent withdrawal penalty is waived for college expenses.

Roth IRAs carry contribution limits and income-eligibility limits. You are only eligible to open a Roth IRA if you fall under a specified income level, so, unlike 529 plans, if you make too much money, you won’t be eligible. If you’re under 50, single and your adjusted gross income is less than $164,000. you can contribute the maximum 2015 contribution limit of $5,500.

Read more

The Case for Saving Early

The cost of attending college is ever-increasing. Adjusted for inflation, the price you pay today to attend a public four-year higher-education institution (not taking into account financial aid) is more than triple what a student paid 30 years ago. At Big 10 schools, the tuition is now about 10 times more than it was in the 1980s.

About 53 percent of parents are actively saving for their child’s college fund. If you fall within these ranks, you already have an advantage. Evaluate your funding, and adjust it based on factors such as rate of growth, income changes or the age of the child. If you haven’t started saving yet, it is not too late to get started. A recent survey conducted by Sallie Mae shows that 40 percent of parents who are not currently saving for college expect to begin saving for college expenses within the next five years.

But the math is clear: The earlier you start saving, the better. Take a look below, and see how compound interest in a general savings account can offer financial benefit.

A parent opens a savings account with an opening balance of $500 when their first child is born.

The parents deposit $250 into the account each month until that child graduates from high school.

By the time the child graduates, 216 monthly payments of $250 were made, totaling $54,500.

In an account compounded quarterly at 6.5 percent, the money would grow to $102,757.46 — nearly doubling the original amount.

[*Starting account balance contribution of $500 with 6.5 percent interest rate, compounded quarterly.]

Half of parents who save for their children’s college funds use general savings accounts. However, a college savings plan may provide even greater financial gain.

College savings plans have several options, and understanding the differences between each type can help determine the best plan to suit your specific needs.

College Savings Plans Questions & Answers

College savings experts Mark Kantrowitz and Stacy Francis offer their insights on the best way to save for college expenses in this Q&A session:

Questions & Answers with Mark Kantrowitz

Q

When should someone start a savings plan?

Parents should start saving for their children’s college educations as soon as possible. Time is your greatest asset. If you start saving from birth, about a third of the college savings goal will come from interest. If you wait until the child enters high school, less than 10 percent of the savings goal will come from interest, and you’ll have to save six times as much per month. (I started saving for my children’s college educations before they were born.)

Q

Can the person funding a college saving plan change the beneficiary?

The account owner can change the beneficiary, not necessarily the contributor. For example, if a parent owns a 529 college savings plan, the parent can change the beneficiary, but a grandparent who contributes to this 529 plan cannot. The beneficiary can be changed to a close relative of the current beneficiary. The only exception is the custodial version of a 529 plan, where the child is both account owner and beneficiary. The beneficiary of a custodial 529 plan cannot be changed.

Q

Can the beneficiary of a 529, Coverdell, UGMA/UTMA or Roth IRA use the money for something other than college?

Yes. In the case of a 529 plan or Coverdell ESA, the beneficiary would have to pay ordinary income tax and a 10 percent tax penalty on nonqualified distributions. An UGMA/UTMA can be used for any purpose. With a Roth IRA, one can take a tax-free return of contributions at any time to pay for anything. Distribution of earnings, however, must wait until normal retirement age, or 59 ½ years old.

Q

Where should or can the funds from a college savings plan be invested?

The money should be invested in an age-based asset allocation that mixes a stock index fund, like [a Standard & Poor’s 500 index] fund, with low-risk investments. It starts off with most of the money in the stock fund and gradually shifts it to the low-risk investment as college approaches. Most 529 plans offer age-based asset allocations, and about two-thirds of families use them.

Q

Are 529 prepaid plans a good idea? What if the beneficiary decides to attend school in another state?

I do not recommend using a prepaid tuition plan. Despite the promises that a year’s tuition is always worth a year’s tuition, most of these plans are suffering from actuarial shortfalls and won’t be able to keep their promises. At least with a 529 plan, you get all the return in addition to having all the risk, and you can manage the risk with an age-based asset allocation. With a prepaid tuition plan, if the student goes to school in another state, you can roll the money into a 529 college savings plan, but the returns may be limited. Some limit you to just 2 percent each year, minus an administrative fee.

Q

How do college savings plans impact applications for financial aid?

If a 529 college savings plan, prepaid tuition plan or Coverdell ESA is owned by the student or by a dependent student’s custodial parent, it is treated as a parent asset on the FAFSA, and distributions are ignored. This has a minimal impact on eligibility for need-based financial aid. If the plans are owned by anybody else — for example, a grandparent — it is not reported as an asset, but distributions count as untaxed income to the beneficiary. This can reduce eligibility for need-based aid by as much as one-half the distribution amount.

Q

Any idea how a small-business owner should handle saving for a child’s college expenses?

Small-business owners should save for their children’s college expenses the same as other parents — by setting up an automatic transfer from their bank account to the college savings plan. Their income may be more volatile, but you prioritize saving for college first, and deal with income shortfalls by cutting other spending.

Q

How should a parent involve a child in saving for college?

First, make the child aware of the college savings plan. This will increase the likelihood of the child going to college — by making it a real possibility. Then, offer to match the child’s contributions to their 529 plan dollar for dollar. Not only will this get them involved, but it also teaches them good money-management skills.

Q

What advice would you give a parent of a newborn on saving for college?

Start saving as soon as possible. Save whatever you can, even if it falls short of the recommended goals: $250 per month for a child who will enroll in a public college, $500 per month for a child who will enroll in a private, nonprofit college. It is easier to increase the amount you save after you get started, as you quickly get used to not having the money in your bank account. When the child no longer needs diapers or day care, redirect the money you were previously spending on those items toward their college savings plan. Ask relatives to give to the college savings plan in lieu of other presents at holidays and birthdays. Sign up for [Sallie Mae’s] Upromise or another rebating program to help your college savings grow.

Q

Under what circumstances are U.S. saving bonds a good idea?

I don’t recommend them other than as a low-risk component of a college savings plan. The interest-free redemptions have very low income phaseouts, making them unsuitable for middle- and high-income families. They also offer very low returns on investment.

Q

What happens if a beneficiary decides that higher-level education is not for them? Is there an expiration date when a college savings plan must be used?

Coverdell ESAs must be used by age 30, except for special needs beneficiaries; 529 college savings plans and prepaid tuition plans do not have an expiration date. If the child decides to not go to college, the account owner can change the beneficiary to a sibling or other relative, even to themselves. One can also take a nonqualified distribution. The ordinary income taxes on the earnings portion of the distribution are no different than if the money had been invested in a taxable account. The 10 percent tax penalty is an added cost, but it is only charged on the earnings portion of a nonqualified distribution.

Q

What is the worst mistake you have seen with a college saving plan?

Investing all the money in an aggressive all-stock fund. While the returns are about double investing in an age-based asset allocation, the risk is also greater. In 2008, the S&P 500 went down by almost 40 percent. Anybody invested in an all-stock allocation suffered great losses, wiping out any earnings and then some. People in age-based asset allocations weren’t as badly hurt. During any 17-year period, the stock market will go down by more than 10 percent two to three times.

The only other candidate for worst mistake is not saving at all. Often, they argue that there’s a penalty for saving in financial aid formulas, so why save? But the penalty is very small if the parent is the account owner, and having college savings makes it easier to choose the right college. Also, every dollar you save is a dollar less borrowed, and every dollar borrowed will cost about two dollars by the time you repay the debt. So, it is cheaper to save than to borrow.

Q

Is there a certain income level or other circumstance for which a savings plan is not necessary or inadvisable?

No. The higher the income, the more useful a 529 plan is, since it avoids paying taxes on the earnings. There are no income phaseouts on 529 college savings plans.

Questions & Answers with Stacy Francis

Q

When should someone start a savings plan?

When it comes to a savings plan, the earlier the better. There is no such thing as too early to start saving. The first step someone should take is to create an emergency fund to cover unexpected expenses as they crop up. This should be done as early as college, if possible. The next step is to contribute to a retirement plan, either at your work, if your employer matches, or by opening a Roth IRA.

Q

Can the person funding a college savings plan change the beneficiary?

Yes. One of the great benefits of starting a 529 plan for a beneficiary is the ability to change the beneficiary if needed. For example, if you started a 529 plan for your niece, who then received a full athletic scholarship, you can easily change the beneficiary of the account to your nephew.

Q

Can the beneficiary of a 529, Coverdell, UGMA/UTMA or Roth IRA use the money for something other than college?

The principal from a Roth IRA can be used as the down payment on your first home. The account must have been open for at least five years, and the growth earned on the account may not be withdrawn without penalty.

You can also use the funds from a 529 [college savings] plan for tuition and fees; room and board (whether it be on- or off-campus); a “reasonable amount” for books, supplies (in some cases, a computer), transportation and miscellaneous expenses; dependent care; study-abroad expenses; loan fees; and employment expenses for co-op study.

Q

Where should or can the funds for a college savings plan be invested?

Each state offers their own 529 plan with various investment options. The site Savingforcollege.com is an excellent resource for those wishing to compare the investment options between state plans. Keep in mind that the fees for each state’s 529 plan vary as well.

Q

Are 529 prepaid plans a good idea? What if the beneficiary decides to attend school in another state?

A prepaid 529 plan is a good option as a method of diversifying college savings, in addition to other college savings vehicles. Funds in a prepaid plan can only be used for tuition and mandatory fees. By prepaying, you are locking in the presumably lower tuition rates of today. There is one nonstate-specific prepaid 529 plan called the [Private College] 529 Plan, which can be used at [almost 300] private colleges. If the beneficiary decides not to attend one of these member colleges, the account beneficiary can be changed, or the money can be rolled over to an ordinary 529 plan, but the earnings will be capped at 2 percent per year.

Q

How do college savings plans impact applications for financial aid?

College savings plans, such as the 529 plan, that are held in the name of the adult, with the child named as the beneficiary, are assessed only up to 5.6[4] percent of the account value when determining need for financial aid. Accounts held in the student’s name, like a[n] UTMA/UGMA, are assessed up to 20 percent of the account value. As you can see, in determining need for student aid, it is more favorable to keep assets in the parent’s name rather than the child’s.

Q

Any idea on how a small-business owner should handle saving for a child’s college expenses?

A small-business owner has the added challenge of uneven cash flow and higher risk as their income is dependent on the success of their business. It is imperative to put lump-sum amounts aside in years that are flush to protect yourself in future years when you might not be able to make a contribution. Whereas the amount that can be gifted to any one person in 2015 without gift tax consequences is $14,000 (the gift tax annual exclusion), a donor can elect to treat up to $70,000 of contributions to qualified tuition programs as being made ratably over a five-year period beginning with the year of the contribution.

Q

How should a parent involve a child in saving for college?

Parents should get their children involved in the process early on. Parents should engage students and let them know how much they are saving for the child’s college and what the costs of college are. Developing a plan for paying for college needs to be a collaborative effort between parents and children. This not only teaches kids powerful concepts regarding personal finance, [but] it can also alleviate fears they may have about funding college once they know how much will be available and what needs to be done to bridge the gap.

According to T. Rowe Price’s “6th Annual Parents, Kids and Money Survey,” kids who are involved in family finances tend to be more confident about money and more motivated to save. For example, children who have talked about saving for college with their parents are more likely to put away some of their own money. This money conversation also increases the likelihood that a child will attend college.

Q

What advice would you give a parent of a newborn on saving for college?

Focus on funding your own retirement first. There are numerous loans and scholarships out there to help college students, and the landscape of higher education is changing rapidly. By the time a child born in 2015 reaches college age, online education via sites such as Coursera, Class Central or CourseBuffet may be a legitimate alternative to the traditional brick and mortal school. The point is, although it is scary to see how rapidly the cost of college is rising, children will still have options in the form of alternative schooling or less-expensive schools, and there is help out there for them. No one will help fund your retirement for you, so start there.

Q

Under what circumstances are U.S. savings bonds a good idea?

I’m not wild about savings bonds as a savings vehicle for college expenses. Savings bonds typically are not the best way to save for college. The rate of growth will be much lower than investing in a diversified basket of stocks and bonds through a 529 plan.

Q

What happens if a beneficiary decides that higher-level education is not for them? Is there an expiration date when a college savings plan must be used?

If the original beneficiary of a 529 plan decides not to pursue higher education or doesn’t use all of the funds, the beneficiary can be changed to another child at any time.

Q

What is the worst mistake you have seen with a college savings plan?

Parents saving in a 529 plan should have a significant emergency fund built up first. I’ve seen parents put money away into a 529 plan, then run into financial difficulties, causing them to withdraw those funds and take the huge 10 percent penalty.

Q

Is there a certain income level (or other circumstance) for which a savings plan is not necessary or inadvisable?

I am not sure of anyone at any income level who would not think the benefit of tax-free growth is worthwhile.