Best Accounts for College Savings

Saving for college is a big job; see how 529 plans, custodial accounts, retirement accounts and prepaid tuition plans can help. Scholarships for college students might assist, but be prepared with your own savings account.
By Richard Barrington

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Paying for college can be daunting, but like most big jobs it becomes easier if you break it up into smaller pieces. In this case, that means spreading the task out over a period of many years (when possible), and using a variety of methods to pay for higher education.

Various college savings accounts have their place in the ultimate solution, and combining the power of several financial tools may enable you to cover the entire cost of a college education.

Paying for college

According to the College Board, annual tuition and fees at public four-year colleges now average $9,410 for in-state students. Attend a private university and the price tag jumps to an average of $32,410, and that’s only tuition and fees. Room, board, books, health insurance and other costs can add significantly to the total cost of attendance. Multiply either number by four or more years, and the total becomes a huge financial burden for the typical family – especially if that family has more than one child.

There is a widely-accepted hierarchy of financial tools you can use to fund college costs. These are listed in order of the most cost-effective approach to the least:

  1. Grants and college scholarships
    These may give you money for college without denting your own family’s resources.
  2. Savings
    Paying for college as you go can lessen the long-term financial burden, and starting early can magnify those savings through investment gains.
  3. Student loans
    These help ease the immediate challenge of paying for college, but create a greater burden in the long run as they accrue interest.

As valuable as grants and scholarships can be, from an early-planning standpoint the place to start is with savings. There’s no way of knowing years in advance if your child(ren) may qualify for grants or college scholarships when the time comes, and loans should be used when needed to fill in the gaps left by other resources.

6 Best college savings options

For those starting early, such as well before your child reaches middle school, there are some excellent college savings plans with various degrees of flexibility. It isn’t necessary to limit yourself to only one college savings plan or custodial account; open at least one yourself and suggest contributions from any relatives who want to help you prepare for college costs.

1. 529 plans

A 529 plan is a college savings plan in which any investment earnings are free of taxation, though the original contributions are not deductible. The money isn’t taxed when taken out of the plan, as long as it used for qualified education expenses. 529 plans are one of the best college savings plans over the long-term. In fact, tax changes passed in late 2017 make 529 plans even more useful than they were before.

When is a 529 college savings plan a good idea? If you start saving at least ten years in advance, you have a long enough time horizon to deploy growth investments such as stocks, and enough years to build up a decent rate of return. Since it is the investment gains and not the contributions to a 529 plan that get a tax break, this longer time horizon allows you to make the most of this tax break.

Given that the 529 plan tax advantage is enhanced the longer your money is invested, it may help to know that there is a way some parents can accelerate their investment in these plans. Annual contributions to a 529 plan are subject to annual gift tax limits, which are currently $15,000 per individual parent or $30,000 for a couple. However, under a special provision you can contribute up to five times those amounts all at once if you elect to have the contribution deemed to apply over a period of five years.

Although making that election means you cannot make any additional contributions over the subsequent five years, getting the full amount invested earlier means there is more time for the account to earn investment returns and reap the tax benefit of doing so in a 529 plan. While such sizeable contributions are beyond the means of most families, there may be situations where you can apply this accelerated contribution approach to some extent.

In addition to their tax advantages, another important characteristic of 529 plans is their flexibility. If you set up a 529 plan for your eldest child, and that child doesn’t fully exhaust the fund during college, you can transfer the balance another 529 plan to benefit another family member without tax consequences.

Recent tax changes have added to 529 plan flexibility by allowing them to also be used for educational expenses before college. You can now use 529 plans for up to $10,000 in tuition expenses for elementary or secondary school.

2. Custodial accounts: UGMA or UTMA

Custodial accounts, either Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) set up at a bank, mutual fund or brokerage firm give a designated custodian full discretion over investment decisions for the benefit of a minor. Custodial accounts have no restrictions on deposits and no penalties for early withdrawal. The disadvantages of a custodial account is that they are taxed annually as well as at withdrawal. In addition, at age 21 the child has complete control over the account and funds.

Funds in a bank custodial account can be held in certificates of deposit, money market accounts or savings accounts. If a custodial account is set up at a brokerage firm or mutual fund, the owner can buy stocks, bonds or mutual funds. Custodial accounts are best used by parents/custodians who are confident that their portfolio management can outweigh the tax consequences of custodial accounts.

3. Retirement savings accounts: Coverdell ESA and Roth IRA

The former Education IRA was renamed the “Coverdell Education Savings Account.” The Coverdell ESA gives individuals a way to save for a child’s elementary/secondary school education, as well as for college, graduate school or vocational school in the same investment vehicle.

The account must be established for the benefit of a child under the age of 18 with all contributions made before the beneficiary’s 18th birthday. Individuals can contribute up to $2,000 annually to a child’s Coverdell ESA if their modified adjusted gross income is less than $95,000 as a single tax filer, or $190,000 to $220,000 as a married couple filing jointly in the tax year in which they contribute. All earnings in the account accumulate tax-deferred and can be withdrawn tax-free if used to pay for any qualified educational expenses.

A Roth IRA can also be used to save for college. When parents save for college using a Roth IRA, the money can be withdrawn with no taxes or withdrawal penalty. If the child does not go to college, the funds stay in the Roth IRA.

Using a Roth IRA for college can be tricky because your money is commingled with retirement funds. Parents need to keep close tabs on their asset allocation as the time to pay for college approaches.

4. Prepaid college savings plans

Prepaid college savings plans offer parents the chance to pay for the future cost of college at today’s prices. This form of college tuition prepayment can lead to large discounts on future costs, especially if education cost inflation outpaces the rate of returns on your college savings accounts. Prepaid plans are available from many different states that can give parents federal and state tax benefits. Plan details vary from state to state.

The Private College 529 Plan is a prepaid plan that offers options for more than 200 major universities, including top-ranked schools such as Stanford, Princeton, Duke University and Washington University in St. Louis. The plan is sponsored by Tuition Plan Consortium LLC and is managed by a subsidiary of TIAA-CREF.

Paying for college early can offer some advantages. If you assume that private college tuition inflation continues at an average rate of 5 percent per year and factor in the Private College 529 Plan annual discount rate of 1 percent, then paying tuition early is the equivalent of earning a 6 percent rate on your college savings funds each year tax-free. Investing college savings in the stock market may beat 6 percent, but the market is volatile and your timing could be bad. The participating universities are contractually obligated to honor the tuition payments (called certificates) issued today, even if the university withdraws from the program in the future.

If a child is not accepted or does not wish to attend a school on the list of participants, there are generally three redemption options:

  • You can get a refund and retain all the tax benefits for the withdrawal portion, if the funds are used for qualified higher education expenses.
  • You can change the beneficiary.
  • You can roll over funds into a state-sponsored 529 plan.

5. College rewards credit cards

Parents can save money for their kids’ college costs as they spend with college reward credit cards. These cards pay cash back from credit card purchases that is deposited directly into a college savings plan, such as a 529 plan. The more you spend, the more you save for college.

Remember that the interest rate on your card can be higher than some other credit cards. If you plan to carry a balance on the card, you may be better off with a low-interest card and making your own 529 college savings contributions seperately.

6. U.S. savings bonds

One of the most traditional forms of college savings is U.S. Savings Bonds. Grandparents, aunts, uncles or family friends can all buy federally-backed savings bonds directly from the Treasury Department in denominations as low as $50. When you buy savings bonds online, you are subject to a maximum of $5,000 in gifts per year for both Series EE Bonds and Series I Bonds.

Savings bonds remain a favorite of senior citizens who appreciate the safety and security that savings bonds offer. College savers who would like more information on U.S. Savings Bonds can visit the Treasury Department’s website.

Smart saving for college starts early by using a long-term savings vehicle, such as those listed above to benefit from tax-advantaged earnings. In the years right before college, it may be helpful to shift your savings into liquid deposit accounts that have little to no risk. If your child(ren) are nearing high school age, review our article on the best accounts for those getting a late start on saving for college.

Frequently Asked Questions

Q: How should I go about choosing a Section 529 college savings plan?

A: Here are some tips that can help you make intelligent decisions about 529 plans:

  • Match the product with your time frame. Since college savings tend to build up as your child approaches college age, as a general rule they should be more conservatively invested than longer-term savings, such as retirement savings. In particular, you should downshift investment risk as the time to draw on the funds approaches.
  • Look at a full range of results. Mutual fund companies like to advertise results in tidy one-year, three-year, and five-year packages. Depending on market conditions, these figures can be misleading. Look at results over a complete market cycle — a full range of rising and falling market conditions.
  • Watch those fees! Fee comparisons are also very important. In particular, avoid anything with a front-end or back-end load.
  • Consider tax advantages in your state. While you have the flexibility to invest in any state’s 529 plan, you might lose tax advantages in your state if you invest in another state’s plan. So if your state has a significant income tax rate, you might want to focus on your home state’s options.
  • Measure the cost against the tax advantage. 529 plans are just one possible way to save for college. The tax advantage is nice, as long as it isn’t offset by excessive fees and limitations on your investment options. In short, make sure you are getting quality investment choices at a reasonable price.

Q: I want to open savings accounts for my two grandsons to start putting aside money for their eventual college education, but I don’t know what approach to take. Any advice?

A: Starting an education fund for a grandchild is a generous and thoughtful idea. Education costs are spiralling out of control, leaving many students heavily burdened with debt by the time they graduate. The earlier you get a jump on saving to offset these costs, the more educational opportunities your grandchildren are likely to have, and the less debt burden they will have as they start their careers.

Here are three things that can help you select the right type of savings vehicle for your grandchildren:

  1. Consider the time frame. You mention savings accounts, and while that is one possibility, you should make sure the type of account matches the amount of time left before your grandsons will start spending this money. If college is still a decade or more in the future, it might not be the best idea to keep all the money in short-term deposit vehicles like savings accounts. Incorporating some stocks into these education funds can provide them with a growth element to help get ahead of inflation. Then, you can start to transition to more conservative investments as the kids near college age.
  2. Look into a 529 fund. You might find it advantageous to save this money inside a Section 529 plan. While contributions to 529 plans are not tax-deductible, any investment earnings on those contributions are tax free as long as they are ultimately used for the beneficiary’s education expenses. Most states nowadays have a wide variety of 529 plans available, which will give you a range of options for choosing an appropriate investment vehicle within this kind of tax-advantaged program. As with any tax-advantaged account, there are rules and limitations that apply to 529 plans, so be sure you understand these before committing your money. The IRS web site is a good source for information on these plans.
  3. Use special checking accounts for students to avoid fees. Once your grandchildren enter college, you may want to help them set up checking accounts to handle their routine expenses. Since the typical student generally maintains a relatively small account balance, fees are a critical issue. While free checking has become more rare in recent years, there are still free checking accounts available, and some banks offer special accounts that cater especially to students.

Speaking of education, as your grandsons get older you can use these college savings vehicles to start teaching them some fundamentals of personal finance. That will equip them with necessary life skills that most people aren’t taught in school.