July 29, 2021• 6 mins
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In the college savings game, all strategies aren't created equal. The best savings vehicles offer special tax advantages if the funds are used to pay for college. Tax-advantaged strategies are important because over time, you can potentially accumulate more money with a tax-advantaged investment compared to a taxable investment. Ideally, though, you'll want to choose a college savings vehicle that offers you the best combination of tax advantages, financial aid benefits, and flexibility, while meeting your overall financial needs.
Tax-advantaged strategies are important because over time, you can potentially accumulate more money with a tax-advantaged investment compared to a taxable investment.”
529 plans are one of the most popular tax-advantaged college savings options. Contributions accumulate tax deferred and withdrawals are tax-free at the federal level if the money is used for qualified education expenses. States may also offer their own tax advantages. (For withdrawals not used for qualified expenses, earnings are subject to income tax and a 10% federal penalty.) 529 plans are open to anyone and lifetime contribution limits are high, typically $350,000 and up (limits vary by state). In 2019, lump sum gifting up to $75,000 is allowed ($150,000 for joint gifts) with no gift tax implications if certain requirements are met.
There are two types of 529 plans: savings plans and prepaid tuition plans.
A 529 savings plan is an individual investment account similar to a 401(k) plan where you direct your contributions to one or more of the plan's investment portfolios. Funds in the account can be used to pay tuition, fees, room and board, books, and supplies at any accredited college in the United States or abroad. Funds can also be used to pay K-12 tuition expenses, up to $10,000 per year.
By contrast, the less common 529 prepaid tuition plan allows you to purchase college tuition credits at today's prices for use in the future at a limited group of colleges that participate in the plan, typically in-state public colleges.
The following table compares the main differences between 529 savings plans and 529 prepaid tuition plans:
| 529 savings plans | 529 prepaid tuition plans |
|---|---|
| Offered by states | Offered by states and private colleges |
| You can join any state's plan (though some plans may require you to enroll with a financial professional) | State-run plans require you to be a state resident |
| Contributions are invested in your individual account in the investment portfolios you have selected | Contributions are pooled with the contributions of others and invested by the plan |
| Returns are not guaranteed; your account may gain or lose value depending on how the underlying investments perform. | Generally a certain rate of return is guaranteed in the form of a percentage of tuition being covered in the future, no matter how much costs may increase by then |
| Funds can generally be used for the full cost of tuition, fees, room and board, equipment and books at any accredited college or graduate school in the U.S. or abroad, or K-12 tuition expenses up to $10,000 per year | Funds can be used only for tuition at participating colleges (typically state colleges); room and board and graduate school generally are not eligible expenses |
A Coverdell education savings account (ESA) is a tax-advantaged education savings vehicle that lets you contribute up to $2,000 per year for a beneficiary's K-12 or college expenses. Your contributions grow tax deferred and earnings are tax free at the federal level if the money is used for qualified education expenses. You have complete control over the investments you hold in the account, but there are income restrictions on who can participate, and the $2,000 annual contribution limit isn't likely to put much of a dent in college expenses.
A custodial account allows a minor to hold investment assets in his or her own name with an adult as custodian. All contributions to the account are irrevocable gifts to your child, and assets in the account can be used to pay for college. When your child turns 18 or 21 (depending on state law), he or she will gain control of the account. Earnings and capital gains generated by the account are taxed to your child each year under the "kiddie tax" rules. In 2019, the first $1,100 of earned income is tax free, the next $1,100 is taxed at the child's rate, and any amount over $2,200 is taxed at your rate.
Series EE and Series I bonds are types of savings bonds issued by the federal government that offer a special tax benefit for college savers. The bonds can be easily purchased from most neighborhood banks and savings institutions, or directly from the federal government. They are available in face values ranging from $50 to $10,000. You may purchase the bond in electronic form at face value or in paper form at half its face value.
If the bond is used to pay qualified education expenses and you meet income limits (as well as a few other minor requirements), the bond’s earnings are exempt from federal income tax. The bond’s earnings are always exempt from state and local tax.
Though technically not a college savings option, some parents use Roth IRAs to save and pay for college. Contributions to a Roth IRA can be withdrawn at any time and are always tax-free. For parents age 59½ and older, a withdrawal of earnings is also tax free if the account has been open for at least five years. For parents younger than 59½, a withdrawal of earnings — typically subject to income tax and a 10% premature distribution penalty — is spared the 10% penalty if the withdrawal is used to pay for a child's college expenses.
Many families rely on some form of financial aid to pay for college, which may include loans, grants, scholarships, and work-study. Financial aid can be based on financial need or on merit. To determine financial need, the federal government and colleges look primarily at your family’s income, but other factors come into play, including your assets and how many children you'll have in college at the same time.
To get an idea of how much aid your child might be eligible for at a particular college, you can use a net price calculator, which is available on every college website. The bottom line, though, is to beware of too much borrowing. Excessive student loan debt — and parent debt — can negatively affect borrowers for years. The lesson? The more you save now, the less you and your child will need to fund later.
Even though college costs are high, don't worry about saving 100% of the total. Many families save only a portion of the projected costs — a good rule of thumb is 50% — and then use this as a "down payment" on the college tab, similar to the down payment on a home. You can use Patelco's college savings calculator to estimate how much you should be saving for college.
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