Have you looked at the price of a four-year degree lately? If you choose a private college, over four years you’ll pay almost $130,000 on average for that diploma.
That’s the price of half a dozen cars or perhaps a small house, depending on where in the country you want to live.
Ouch.
No matter how old your kids are — or even if you’re just imaginung becoming a parent at this point — the time to start saving for that big-ticket education is definitely now. In fact, the sooner you start, the longer you’ll have to take advantage of the magic of compound interest as you watch your savings accrue.
So how should you get started? There are several ways to save for college, each with its own advantages and disadvantages.
529 College Savings Plans
A 529 education savings plan is a tax-advantaged investment account that you can use for qualified education expenses. These plans are similar to retirement accounts in that they offer certain tax breaks, but only if you use them for approved education purposes. If you end up pulling the money out for another reason, you’ll pay taxes and a 10 percent penalty.
529 plans are administered by the states, so there are lots of choices available — there’s no rule saying you have to choose the plan that’s run by the state where you live. You may want to, though, since a handful of states offer a break on their state income taxes for contributions to their plans. If this doesn’t apply to your state, it’s best to research plans based on their performance.
Pros:
- No taxes on your earnings
- Potential for state tax deductions
- Most costs are eligible, including tuition, room and board, books, and supplies
- Because the account is in the parent’s name, you can change beneficiaries to include siblings, grandchildren and even yourself
- High contribution limits: up to $14,000 per year to stay within federal gift tax limits
Cons:
- As a brokerage account, 529 plans aren’t FDIC-insured, and it’s possible to lose your earnings and even the principal if the market takes a nosedive
- If you run into an emergency and need to withdraw cash for anything other than education expenses, you’ll pay taxes on your earnings plus a 10 percent penalty on your withdrawal
- 529 plans typically offer a few mutual fund options, but you won’t be able to come up with a custom investment plan where you can fine-tune the percentages of stocks, bonds and other investments
- Fewer investment options mean you can’t shop around for lower-fee index funds
Coverdell Education Savings Account
Also known as the Coverdell ESA, this account allows you to pick and choose your investments as you wish, and you can change them as often as you like to rebalance your investment or add new options. This is more like a brokerage account and less like the simplified, limited-choice model of the 529.
Coverdell accounts also allow you to use the funds for K-12 private school expenses. This used to be a differentiator, but the new tax law for 2018 now allows 529 dollars to be used for K-12 expenses as well.
Pros:
- No taxes on your earnings
- Most costs are eligible, including K-12 education expenses
- Like the 529, you can change beneficiaries to include siblings, grandchildren and other family members
- A wide range of investment options
- The freedom to change your investments regularly
Cons:
- Low contribution limits capped at $2,000 per year
- Income limits reduce the amount you can invest if you make more than $95,000 per year
- Not FDIC-insured, so you could lose money
- You must spend the money by the time the beneficiary turns 30 or pay a 10 percent penalty on the amount that’s left
Roth IRA
Though technically a retirement plan, the Roth IRA allows investors to make withdrawals for college expenses without paying the penalty that’s normally charged when you take out retirement money early. Unlike a traditional IRA, the money you put into a Roth happens after taxes, so you won’t be taxed on the principal or earnings ever again.
While it’s generally risky to dip into your retirement fund early, the flexibility of a Roth makes it a good choice for some investors.
Pros:
- You can withdraw your principal — the amount you contributed — at any time, with no penalty, to use for anything you want
- You can withdraw earnings without the 10% penalty that normally comes with early retirement account withdrawals if you use the money for higher education expenses
- You have total control over your investment strategy and can shop around for low fees, etc.
- The money stays in your name rather than having to name a beneficiary
Cons:
- Annual contribution limits of $5,500 per year if you’re under age 50; $6,500 per year if you’re over age 50
- If you take money out for higher education expenses before age 59 1/2, you’ll have to pay capital gains taxes on the earnings (though not the principal)
- Pulling money from your retirement account can leave you short on funds later in life if you don’t have other sources of retirement savings, such as a 401(k) or pension
- Withdrawals from your Roth count as income for FAFSA calculations, which could reduce your child’s need-based financial aid package
So which plan is right for you? It depends on what you value most. If you’re a savvy investor who wants control over how you allocate your funds, a Coverdell or Roth will be more appealing. If you already have your retirement in order thanks to a strong 401(k) with matching funds from your employer, a Roth won’t be a big gamble for you since you can afford to make some withdrawals without putting your retirement plans on hold.
For most American families, though, the 529 plan offers the best combination of tax breaks without forcing you to spend the money on college for a certain beneficiary if they end up having other plans. Because it comes with a high contribution limit and the ability to name many other beneficiaries, it’s a good way to take advantage of the tax savings while putting money aside for college.
No matter which plan you choose the most important thing is to open one and make start making a monthly contribution — no matter how small — right now.
