What Type of College Savings Account Is Best?

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What Type of College Savings Account Is Best?

When you’re a parent, saving for your child’s college education may be one of your top priorities. You want to reduce the amount of money they have to take out in student loans and prepare for the future. 

A college education is expensive. Estimates right now are that the average yearly tuition bill for a four-year private university is nearly $47,000. For a four-year public school, out-of-state students might end up paying up to $37,000 a year, and these costs are only going up. 

Even going to a two-year community college can be around $12,000 a year. 

With that in mind, the following are some of the college savings accounts that are available, so you get an overview of what your options are as a parent. 

The Basics

There are a lot of ways a family can start to save money for college but opening a 529 college savings plan is the most popular. There are a few different 529 college savings plans, which we’ll talk more about below. 

A 529 plan tends to be what experts agree is the best way to save for college. The money grows tax-free, as long as funds are used for qualified education expenses. 

Other options include Coverdell accounts, custodial accounts, prepaid tuition plans, and you always have the option of using a traditional savings account or investing in the stock market. 

You also have to remember that while saving for your child’s education is certainly a goal you should have, it’s not your only financial goal. Saving for college should come after you have an emergency fund, you pay off your major debt, and you invest some of your household income for retirement. 

What Are 529 Plans?

A 529 plan is tax-advantaged. These accounts are a way to save to pay for the costs of education, and they aren’t limited only to post-secondary costs. In 2017 these accounts were expanded to cover K-12 education, and in 2019 there was an expansion to cover apprenticeship programs. 

There are two major types of 529 plans—savings plans and prepaid tuition plans. 

A savings plan grows tax-deferred. The withdrawals are tax-free as long as they’re used for qualified education expenses. 

With a prepaid tuition plan, the owner of the account can pay in advance the tuition costs at designated universities and colleges, so they’re basically locking in the current rates. 

Anyone can open a 529 plan, but they’re most often established by either parents or grandparents on behalf of their child or grandchild. The child or grandchild is the beneficiary of the account. 

Until the money is withdrawn, it grows tax-deferred. As long as you use the money for qualified education costs defined by the IRS, the withdrawals aren’t subject to any state or federal taxes. For K-12 students, the tax-free withdrawals are capped at $10,000 a year. 

The two primary types of 529 plans are college savings plans and prepaid tuition plans, which are pretty distinct from one another. 

College Savings Account

Savings Plans

The most common type of 529 plan is the savings plan. With the savings plan, an account holder contributes money that’s then usually invested in a selection of mutual funds. You can choose if you’re the account holder, which funds you want to invest in, and how the funds perform will determine how the account grows. 

Prepaid Tuition Plan

A prepaid tuition plan isn’t available in every state, and there are variations in the specifics. The general idea shared is that you can lock in tuition at the current rates for a student who may not be attending college for a number of years. 

The plan grows in value over time, or at least that’s the hope. A prepaid tuition plan doesn’t cover room and board, unlike a savings plan. 

There are also more restrictions on these accounts, like which college they can be used for. 

Education Savings Account or Education IRA

An Education Savings Account or ESA is similar to a Roth IRA, with the difference that it’s used for expenses related to education. You can invest up to $2,000 after-tax per year per child, and the money grows tax-free. 

The rate of growth for an ESA is based on the investments the account holds. 

The ESA is often going to offer a higher rate of return than what you’d get from a typical savings account, and you don’t have to pay taxes when withdrawing the money if you’re using it for education expenses. 

Contributions are limited, and you have to be within the income limit to qualify. The amount has to be used by the beneficiary by the age of 30 as well. 

Other Options

There are other options that are less popular than the ones detailed above. For example, there is a custodial account. 

The benefit of a custodial account is that the earnings are taxed at the child’s tax rate, which is likely to be much lower than that of their parents. 

You can contribute up to $15,000 a year as an individual, or $30,000 a year as a couple, without having to pay gift tax. Then depending on the rules in your state, you could theoretically transfer control to your child when they turn 18. 

You can also invest in the stock market without using a particular education account. It is a high-risk investment, and you have to weather the ups and downs of the market. 

If you have the resources to work with a financial investor, that can be a good option, or you can use a robo-investor. You will have to pay capital gains on your earnings, so there aren’t tax advantages to saving for your child’s education with stocks. 

Finally, if you have a traditional savings account, of course, this can be used as well. The benefits are that it’s easy to manage and make deposits, but the interest rates tend to be low, so you’re not going to grow the money in the account as much as you would with other options. 

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