What are the best ways to save money for college?

With the cost of higher education rising annually, saving for your child’s education is on every parent’s mind. There are several vehicles designed specifically for this, including state savings plans, prepaid tuition plans, Coverdell education savings accounts, and custodial accounts. Each option offers different advantages and presents potential disadvantages.

529 plans: state savings plans

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. A state savings plan is a tax-advantaged qualified education expense savings vehicle governed under Section 529 of the Internal Revenue Code (IRC)—hence the name “529” plans. A state savings plan lets you save money for higher education in an individual investment account. Some plans let you enroll directly, while others require that you go through a financial professional. The details of these plans vary by state, but the basics are the same:

Advantages. Anyone can open a state savings plan account. Your ability to contribute doesn’t depend on your income or on your status as a parent. Money in the plan can be used at any college in the United States or abroad that is accredited by the U.S. Department of Education. And, if your child decides not to go to college or gets a scholarship, the account can be transferred to a sibling or other qualified family member without penalty. Plus, if you are unhappy with your plan for any reason, you can switch (roll over) your funds to a different 529 plan (a different state savings or prepaid tuition plan) once every 12 months without penalty. Your state may even offer tax breaks, such as a deduction for contributions or tax-free withdrawals.

Drawbacks. You relinquish some control of your money, returns aren’t guaranteed (you roll the dice with the investment portfolios you’ve chosen), and your account may gain or lose money. Also, there are usually fees associated with opening and maintaining an account (e.g., an annual maintenance fee, administrative fees, and investment expenses based on a percentage of total account value).

529 plans: prepaid tuition plans

Although prepaid tuition plans are similar to state savings plans in that they are governed under Section 529 of the IRC, the two plans are different. A prepaid tuition plan is a tax-advantaged savings vehicle that lets you prepay tuition expenses now for use in the future.

Prepaid tuition plans can be run by states or colleges. For state-run plans, you prepay tuition at one or more state colleges; for college-run plans, you prepay tuition at the participating college(s). Although the details of prepaid tuition plans vary according to state, the basics are the same:

Drawbacks. One major disadvantage is that your child is limited to the participating colleges (if your child attends a different college, plans differ on how much money you will get back). Also, if the plan earns more than the relevant college inflation rate, you are not necessarily entitled to the difference. Keep in mind, too, that fees are associated with opening and maintaining the account (e.g., an enrollment fee and administrative fees).

Coverdell education savings accounts

A Coverdell education savings account (Coverdell ESA) is a tax-advantaged education savings vehicle that lets you save money for college, as well as for elementary and secondary education (K through 12) at public, private, or religious schools. Here’s how it works:

Drawbacks. Not everyone can open a Coverdell ESA. Your ability to contribute depends upon your income. To make a full contribution, single filers must have a modified adjusted gross income (AGI) of $95,000 or less, and joint filers must have a modified AGI of $190,000 or less.

Custodial accounts

Before 529 plans and Coverdell ESAs, there were custodial accounts. A custodial account allows your child to hold assets that he or she ordinarily wouldn’t be allowed to hold in his or her own name. The assets can then be used to pay for college or for anything else that benefits your child (e.g., summer camp, braces, hockey lessons, or a computer). A custodial account follows the subsequent process:

Drawbacks. Despite the potential tax savings, custodial accounts have a serious drawback—all gifts to a custodial account are irrevocable. When your child reaches the age of majority (as defined by state law, typically 18 or 21), the account terminates and your child receives the money free and clear of parental influence. Some children may not be able to handle this responsibility or might decide not to spend the money for college.

Impact on financial aid

Your decisions on how to save for college expenses impact the financial aid process. When the time comes to apply for financial aid, your family’s income and assets are run through a formula at both the federal and the college (institutional) levels to determine how much money you are expected to contribute to college costs before you receive aid. This number is referred to as the expected family contribution or EFC.

In the federal calculation, your child’s assets are treated differently than your assets. Your child must contribute 20 percent of his or her assets each year, while you must contribute 5.6 percent of your assets. For example, $10,000 in your child’s bank account would equal an expected contribution of $2,000 from your child ($10,000 x 0.20), but the same $10,000 in your bank account would equal an expected $560 contribution from you ($10,000 x 0.056).

A custodial account is classified as a student asset. In contrast, Coverdell ESAs, 529 state savings plans, and 529 prepaid plans are considered parental assets if the parent is the account owner (accounts owned by grandparents or other relatives or friends don’t count). Beginning with the 2009–2010 school year, custodial versions of 529 plans and Coverdell ESAs are treated as parental assets. In addition, withdrawals from Coverdell ESAs and state savings plans used to pay the beneficiary’s qualified education expenses are not classified as parent or student income on the federal government’s aid form. This means that some or all of the money is not counted again when it is withdrawn; however, withdrawals from prepaid tuition plans are counted. Specifically, any distributions from a prepaid tuition plan reduce your child’s cost of attendance. As a result, every dollar that comes out of your prepaid tuition plan will reduce your child’s potential aid award by one dollar.

We are here to help

Trying to decipher which college savings plan is right for you can be enormously challenging. We are here to help you determine which savings vehicle best fits your financial situation—and, most important, your family’s needs. We know that family members play a primary role in your life and in your financial decisions. That’s why we always keep them in mind when we work with you to manage your wealth.

Saving for college is on every parent’s mind. Contact the financial professionals at MaPP Investment Services at (330) 339-6308 or submit a form to learn more.

The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that an education-funding goal will be met. In order to be federally tax-free, earnings must be used to pay for qualified education expenses. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10-percent penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.