If you have a young child, you’ve probably heard that education is key to their future success. You’ve probably also heard about – or even experienced firsthand – skyrocketing higher education costs. With that in mind, you might wonder about the best ways to save for your child’s education.
Of course, if they’re young enough, you may not know their interests, passions, or preferences. But the earlier you plan, the more financially prepared you’ll feel when the time comes.
So, how do you save for your child’s college education when it’s too early to consider AP classes, grants, and scholarships?
Best Ways to Save for Your Child’s Education While They’re Young
If your children are young, time is on your side. But college costs are likely to rise as they age. As such, stashing money in a regular savings account just won’t be enough. While you’ll protect your cash from the stock market’s ups and down, you’ll actually lose money thanks to inflation.
Instead, it’s wise to find ways to make your money grow – or lock in more affordable college costs now. Here’s how.
529 Plans
A 529 plan, or qualified tuition plan, offers tax benefits to those who save for their education. Each parent can deposit up to $16,000 per year tax-free into a 529 plan. You can also “supercharge” a 529 plan with a lump sum up to $80,000 – five years’ worth of contributions – penalty-free.
529 plans also come with favorable financial aid treatment when your child fills out their FAFSA. Since they count as parent assets, they have a smaller impact on your child’s financial aid benefits. And regardless of who owns the plan, qualified withdrawals aren’t reported as income.
But how does a 529 savings plan work?
Educational Savings Plans
Educational savings plans work similarly to Roth 401(k)s or IRAs. Essentially, you open a state-sponsored account and invest after-tax dollars in mutual funds, ETFs, or target-date funds. Then, you can enjoy tax-free growth until you make qualified withdrawals.
Generally, qualified expenses include up to $10,000 per year for pre-college educational expenses. There’s no cap on paying for college tuition, fees, supplies, or room and board.
Prepaid Tuition Plans
Prepaid tuition plans, also called guaranteed savings plans, work differently. Instead of saving money, you “pre-purchase” college credits or tuition now. Then, your child can “redeem” the credits later without paying for them again.
States, public colleges, and private universities may all sponsor prepaid tuition plans. However, most plans are only available at a few institutions, and you usually have to live in the same state. And if the state doesn’t guarantee your plan, you risk losing your money altogether if the college encounters financial trouble.
Pros and Cons of College 529 Plans
Pros:
- Plenty of tax benefits
- States manage your investments
- Contribute up to $15,000 per person, per year tax-free
- Tax-free growth on eligible withdrawals
Cons:
- You must use the money for educational expenses
- Can affect financial aid eligibility
- Prepaid tuition plans aren’t offered by every state or university
- You risk losing money if your plan isn’t state guaranteed
Coverdell Education Savings Accounts (ESAs)
A Coverdell Education Savings Account lets you set aside money to cover educational expenses for a person under 18. You can invest the money in stocks, bonds, mutual funds, ETFs, or other investments. They money grows tax-free, and all qualified earnings are tax-free too.
Coverdell ESAs share several similarities with 529s. For instance, you can’t write off contributions on your taxes. However, you can spend up to $10,000 per year on K-12 expenses, or unlimited amounts on higher education expenses. And when it comes to the FAFSA, the value of the account is attributed to parents, not students.
But Coverdell ESAs have several important differences, too.
To start, they’re offered through banks or brokerages, not states, and you can only contribute $2,000 annually per beneficiary.
Additionally, you have to fall under the income criteria to contribute to a Coverdell account. (Current limits are set at $110,000 for individuals or $220,000 for married couples filing jointly.)
Finally, you can’t contribute to a Coverdell once the beneficiary turns 18. Plus, they must use the funds before they turn 30.
Pros and Cons of Coverdell ESAs
Pros:
- FDIC insurance coverage included
- Accounts come with federal and state tax benefits
- You can use the funds for K-12 and college expenses
- The value is attributed to parents for FAFSA purposes
Cons:
- Income and contribution limitations
- Non-qualified withdrawals are taxed
- Contributions aren’t tax-deductible
- The beneficiary must spend the funds by age 30
Custodial College Accounts under UGMA/UTMA
Another way to save for your child’s college education is to open a custodial brokerage account. Depending on the state, you may have two options:
- Uniform Gifts to Minors Act (UGMA) accounts, which let you donate basic assets like:
- Cash
- Stocks
- Bonds
- Mutual funds
- ETFs
- Uniform Transfers to Minors Act (UTMA) accounts, which let you donate a broader range of assets, such as:
- Cash and investments
- Annuities
- Life insurance
- Real estate
- And art
Aside from their asset allowances, UGMA and UTMA accounts function essentially the same way. You can open these custodial brokerage accounts at a bank or investment firm. Then, parents, guardians, or loved ones can donate assets to the beneficiary. When the child reaches their state’s age of majority (usually 18-21), the assets will transfer to their name.
Note that any contributions made to custodial accounts are considered irrevocable gifts. That means you can’t “take back” a contribution; withdrawals must be used in the child’s best interest.
UGMA and UTMA accounts don’t come with contribution or use limits. That said, any amount over $16,000 per contributor, per year will trigger the gift tax.
Additionally, because they’re not education-specific accounts, they come with very limited tax benefits. Moreover, their balance counts toward the students’ assets on the FAFSA, which can limit a child’s financial aid eligibility.
Pros and Cons of UGMA and UTMA Accounts
Pros:
- No investment, withdrawal, or spending limitations
- No penalties if funds are used by the child or for the child’s needs
- The value of the account is removed from the donor’s estate for tax purposes
Cons:
- Tax benefits limited to the first $2,300 in the account
- Parents can’t dictate how students spend their funds
- Custodial accounts count as student assets on the FAFSA
- Assets must be spent or withdrawn by age 30
Use Your Roth IRA to Invest for Your Child’s College Education
A Roth IRA, or individual retirement account, allows you to contribute after-tax income and earn tax-free interest. You can withdraw all of your funds once you turn 59.5 years old without paying taxes or penalties. And unlike some retirement accounts, you can withdraw your funds to pay for qualified educational expenses without paying penalties. (Though you will have to pay income tax on any earnings – not contributions – you withdraw.)
For some, using your Roth IRA to save for your child's education makes sense. Still, you should weigh the downsides carefully.
To start, not everyone can contribute to a Roth account. Additionally, the money may count as untaxed income for the beneficiary, which can affect future need-based financial aid. And if you don’t have another retirement plan in place, you risk jeopardizing your own financial future.
Pros and Cons of Using Roth IRAs for College Costs
Pros:
- Withdraw contributions anytime for any reason penalty-free
- 10% early withdrawal penalty on earnings is waived when funds cover qualified higher education expenses
- Broad range of investments available
- Retirement accounts don’t count as assets on the FAFSA until funds are withdrawn
Cons:
- Married couples earning over $214,000 or individuals earning over $144,000 can’t contribute to Roth accounts
- The maximum annual investment in 2022 is $6,000 ($7,000 if you’re over 50)
- Withdrawn funds count against the beneficiary on future financial aid applications
- Cashing out your Roth IRA may jeopardize your retirement plan
Bond Laddering with Qualified U.S. Savings Bonds
If you want to safely invest for your child’s college education, you can also look into Qualified U.S. Savings Bonds. These are debt securities issued by the Department of Treasury and backed by the U.S. government.
Essentially, when you buy a bond, you’re lending money to the government. In return, you receive interest payments for a set number of months or years. Then, when the bond matures, you get your initial investment back.
For instance, say you invest $10,000 in 4% interest bonds with 10-year maturity dates. Every year, you’ll receive $400 in interest. Then, when the bonds mature, you’ll receive your initial $10,000 investment back.
You can also use bonds to “ladder” your investments. With this technique, you buy a series of bonds that mature at different dates. This ensures that you receive a series of interest payments on a regular schedule. Then, when each bond matures, you can use the money to buy more bonds and keep the ladder going.
Many people use bond laddering as a retirement investment technique. But there’s no rule saying you can’t do it for your child’s college education! (Ideally, you’d buy bonds that mature in the years your child attends college.) Best of all, Series EE and Series I bonds come with tax advantages if you use the interest for qualified higher education expenses.
Pros and Cons of Investing in Bonds for College Expenses
Pros:
- Series EE and Series I bonds may be redeemed tax-free for qualifying higher education expenses
- Low-risk investments backed by the U.S. government
- Minimal financial aid impact
Cons:
- You can only invest $10,000 per year ($20,000 for couples) per year, per type of bond
- Interest will be subject to taxes if not spent on tuition or qualifying fees
- Bonds may generate smaller returns than some types of investments
- Not all bonds come with education-based tax advantages
When Should I Start Saving for My Child’s Education?
In the last 20 years, in-state tuition and fees at public universities have soared 212%, with out-of-state costs rising 165%. Meanwhile, private universities have increased their rates by 144%.
According to EducationData.org, that comes out to an average rise of 9% per year for nearly two decades. But, even if we assume a more moderate annual increase of 7% and a baseline cost of attendance of $25,500 in 2022, a 4-year in-state degree will still cost $382,700 by 2040.
That’s nearly $96,000 per year!
Don’t Wait to Save for Your Child’s College Education!
Rapidly escalating college costs may have you worried about how your child will afford their future education. After all, $100,000 is more than most people make in a year!
But with some careful planning, you can start saving for your child’s college education now. With time and a little luck, you may be able to gift them a fully paid-for college education. And if they qualify for financial aid later, you can still use the funds to jumpstart their new lives. (Or set aside a little something for a family vacation. After all, you deserve a treat, too!)