College savings plans are a great investment in your children’s future. Whether you are looking for the best college savings account or a stellar education savings plan, doing the heavy lifting for higher education financing now will save you and your child money in the future.
Without a sound financial strategy, interest costs can make it difficult to start retirement savings, plan for a home purchase or even establish an adequate emergency fund. Saving for a kid’s college as early as possible and planning for other funding opportunities helps minimize the need for loans and makes it possible for them to move on with life debt-free after graduation.
“We consider loans to be pretty close to a last option (for funding),” says Colleen Brown, director of financial aid at Columbia College. “They are typically better than a credit card, but outside of that, if a student can get funding that isn’t a loan, we would recommend that first. Major funding opportunities include the federal government through the FAFSA, state aid, national college searches, local scholarship options and, of course, colleges and universities.”
Clearly, there are a number of factors to consider when determining how much to save for college — and how college savings plans can help you secure the necessary funding.
The Best College Savings Plans for 2020
|Account Name||Annual Contribution Limit||Tax Benefits?||Room and Board?|
|Coverdell Education Savings Account||$2,000||Yes||Yes|
|529 Prepaid Plan||Varies by state||Yes||No|
|529 Savings Plan||Varies by state||Yes||Yes|
College Savings Plan Basics
A college savings plan allows parents and guardians to save cash used for higher education expenses for children. Different accounts feature unique rules and various pros and cons for investors, making choosing how to save for college a difficult decision. The best way to save for college for your family may actually be a combination approach.
For example, families with less disposable income may invest in some tax-advantaged accounts but choose to keep other savings more liquid in traditional savings. This means access to fewer tax benefits but also helps avoid penalties if the funds are needed for additional expenses. The money will also be more readily accessible in traditional savings vehicles versus education-specific accounts.
529 Prepaid Plan vs 529 Savings Plan
One of the most popular ways to save money for college is 529 plans. According to the Securities and Exchange Commission, states, state agencies and educational institutions also offer 529 plans in one or both of two different types: the prepaid tuition plan and the education savings plan. Rules vary slightly from state to state, but the primary differences between the two plan types revolve around limitations.
Both types provide access to tax benefits. These include contributions growing in the account, tax-free and no taxes on withdrawals used for eligible education expenses. Many states also allow you to deduct contributions from your taxable income, resulting in immediate tax savings. For example, Missouri allows married/filing jointly taxpayers to deduct up to $16,000 from taxable income each year.
With the prepaid plan, parents purchase units and credits at state colleges at current fees to cover future costs. This allows parents to “lock in” savings if the cost of tuition continues to rise. Some states guarantee the money paid but others do not, so it is possible to lose funds prepaid to state schools or receive only a minimal return on investment if the student goes to school out of state.
By contrast, the savings plan is an investment account. Unlike the prepaid plan, it can cover room and board expenses. The plan can invest in multiple options including mutual funds, exchange-traded funds (ETFs), and other products. This provides the flexibility of many retirement savings vehicles and the option to tweak investments to more conservative options as a student reaches college age.
Savings Account vs Education Savings Account
As of January 2020, most traditional savings accounts offer interest rates of less than 1% while money market accounts and CDs provide only slightly better rates, on average. By comparison, a Coverdell Education Savings Account allows savers to invest in their favorite areas and, potentially earn a higher return, but contributions are limited each year. The account is also only available for earners who meet certain income criteria.
Sometimes referred to as an education IRA, the education savings account is available in full for married/filing jointly tax filers with a modified adjusted gross income of $190,000 or less or single filers with a modified adjusted gross income of $95,000 or less. A maximum contribution of $2,000 per year per student is allowed until the student turns 18. Contributions are after-tax, but earnings are tax-deferred and withdrawals may not be taxed at the federal level if used for qualified expenses. Funds must be used by age 30, making it perfect for potential career students or for families planning for college costs through graduate school.
Retirement Loan vs Education Savings Account
Some parents opt to save for college in their retirement accounts and then access loans to pay for expenses. Loans from many retirement counts charge interest at the prime rate plus an added percentage. The rate is often lower than those of many other loan types. You do not have to pay a tax penalty or taxes on a loan from a retirement account if it is paid off. However, if you switch jobs or rotate the plan to a new provider, the outstanding loan balance may be deducted from your overall balance at the time of the transition and then treated as a withdrawal. This would expose you to penalties and interest. Always read the fine print before taking a loan on a retirement account.
The 3 Best College Savings Plans for 2020
Coverdell Education Savings Account: Best for multi-student savers
A Coverdell Education Savings Account is an excellent savings vehicle for parents with the ability to save a little every year. The $2,000 limit is per child, making it ideal for families with multiple children. An account can be opened with various financial and investment firms, and it can be invested in an ETF or mutual fund or self-directed. As long as funds remain in the account until used for education expenses, the withdrawals are not taxed. For the purposes of an ESA, qualified expenses can include the costs of elementary school and high school tuition if you transition your child to private education or experience financial difficulties during a school year.
529 prepaid plan: Best for in-state schools
For long-time residents of a given state, a 529 prepaid plan provides access to state tax benefits. It also allows parents planning on sending children to a state school with the ability to prepay costs at a reduced rate. Plans may be through a school system or for a specific university and feature price ranges based on the age of a child at the time the plan starts. After signing up for this plan, expenses can be paid all at once, over a fixed multi-year period or through a monthly payment plan. Always review payment options to maximize the tax benefits of contributions as some states cap the tax deduction allowed each year. The prepaid plan does not allow for early payment of room and board expenses, making it necessary to direct some savings elsewhere if the student plans to live on campus.
529 savings plan: Best for tax benefits while saving
A 529 savings plan more relies on investments. It allows savers to choose between investments in mutual funds or ETFs, meaning returns can go up and down depending on the market. With a direct-sold plan, investors specifically chose how to invest the money based on provided options, but can also select an adviser-sold plan. These 529 plans are managed by financial advisers at an investment firm. Much like a retirement account and education savings account options, investors can start off with investments with greater potential for returns and steer toward conservative options as college looms on the horizon. The 529 savings plan allows for spending on room and board as well as tuition and other school fees without tax implications. Contributions grow tax-free and taxes are not charged on withdrawals when used for education costs.
The Final Word
The best college savings plan for your family may be a mix of plans with different options for each student. A family with a candidate for a state school and an out-of-state-bound student with scholarship potential may find a 529 prepaid plan best for one child and an ESA a good option for another. The overall tax benefits of a 529 savings plan may help one large family maximize contributions through state tax benefits while a Coverdell will ensure that each child receives equal funding. Always assess all options and start saving as early as possible, even if it’s just a few dollars. Over 18 years, a small monthly contribution can pay big dividends as earnings on investments compound over time.