7 of the Most Important Savings Vehicles for a College Education

7 of the Most Important Savings Vehicles for a College Education

One of the most stressful financial situations for parents is figuring out how they will cover college expenses for their children. Parents make a lot of mistakes when saving for college, the biggest of which is not starting to save early enough.

New parents should familiarize themselves with the college savings plans available and then choose one to begin saving. The costs of college only seem to be increasing, so parents will be best served by starting to save as early as possible. A wide number of different options exist to save for college tuition.

Some of the key options to consider include:

1. Coverdell Education Savings Account

This trust account is a tax-deferred vehicle for saving for educational expenses. Parents can use the money to cover the costs of education at any level, as well as associated expenses like room and board.

The earnings in the account accumulate tax-free. Also, distributions can be made without any taxes due as long as the money is used for qualified educational expenses. The major downside of this account is the fact that funds must be used by age 30 or tax penalties will start to be charged.

2. 529 Plan

A 529 Plan is one of the most common vehicles used to save money for college. These plans are usually sponsored by state governments rather than federal organizations, so the exact details can vary between states. Many states will allow parents to deduct contributions to the 529 from their state income tax. When the money is withdrawn to pay for tuition and associated expenses, individuals will not need to pay taxes.

Importantly, individuals can put money into any 529 plan, so if another state has a better option, it is possible to set up an account there instead. In general, parents can open a 529 with a rather minimal initial deposit.

3. Custodial Account

Parents may want to opt for one of two custodial accounts, Uniform Gift for Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). These two accounts are very similar, but UTMAs can hold real estate in addition to the assets available to UGMAs, which include cash, mutual funds, stocks, and more.

No limits exist on how much can be deposited into the account, but it is important to recognize that children will have legal access to the money when they turn 18. As a result, they will be able to use the money for purposes other than college if they choose.

4. Permanent Life Insurance Policy

Higher net worth families often use permanent life insurance policies to save for education in a tax-advantaged manner. This vehicle is a conventional life insurance policy with some of the money from the premium earmarked for a death benefit and some for a tax-deferred savings account. The money in this tax-deferred account can be accessed at any time for any reason, so individuals can use it to save for more than just college.

The main pro of this option is the fact that it offers a death benefit and other living benefits, plus there is no penalty for using the savings for purposes other than education. Also, the policy does not count as an asset when being considered for financial aid by a college. However, the policy does include upfront and recurring fees.

5. Eligible Savings Bonds

Some savings bonds are designed to help with the costs of college. When individuals put money into these savings bonds and then use the money to pay for higher education, they can exclude the amount from their taxable income. Importantly, the money cannot be excluded if used for room and board. Savings bonds are guaranteed by the government and thus pose very small risk. At the same time, however, the interest earned on the money is quite low.

6. Mutual Funds

Individuals who want to take a bolder approach to investing can opt for mutual funds. Money earned from mutual fund investments is subject to annual income taxes and capital gains from selling shares gets taxed. Furthermore, mutual funds are considered an asset when students are assessed for financial aid eligibility. The risk involved with mutual funds is greater than with savings bonds, but the chance for growth is also higher.

7. Roth IRA

For the most part a Roth individual retirement account (IRA) is associated with retirement savings, but more people are starting to use it with educational goals in mind. A Roth IRA is funded with after-tax dollars and the money grows without any tax implications. Furthermore, no taxes are due when qualified withdrawals are made. If your Roth IRA has been open for at least five years, for example, contributions can be withdrawn without penalty if they are used for qualified educational expenses.

The growth potential with a Roth IRA is higher than with other investment options. Also, if any child decides not to attend college, the money is already saved for retirement. However, if the money is spent on your child’s education, it is no longer available for you in retirement.

Another downside to a Roth IRA is that relatives cannot contribute to it as they can with a 529. Additionally, withdrawals count as income, which may impact your children’s eligibility for need-based financial aid. Individuals should feel free to talk about Roth IRA as a potential educational savings vehicle with a financial advisor if they think it could be a good option.