Ultimate Guide: The Best Places To Save For College

The Best Options For College Savings

You have 18 years once your child is born until they’re heading off to college.  Nothing like that ticking clock to start a flood of anxiety.

While a college degree isn’t necessary, it’s not as optional as it was in the past.  There’s not a guarantee of a good long-term job. Most people in our generation have never worked a job with a pension offering.

Despite your stance, a college education is still an asset in today’s economy.  Many jobs list a bachelor’s degree as a must. That doesn’t mean you need to jump into debt though.

You most likely won’t need a fancy private college with name recognition except for some very specific jobs. Most graduates would be well served to attend their local state school.

Even if you go to the local school or do community college, college is expensive so it’s best to start saving early and often. Especially since the average household debt in the United States is $135,000.

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Where Should You Save Money For College?

Deciding where to put the money you’re saving for college can be a tricky question. There are so many options out there and even more options within each type of savings plan.

Some people say not to bother saving for college at all while others recommend a regular savings account. Others even recommend saving in your own retirement so that way if your child decides not to attend college, you get to keep the tax free growth.

Don’t worry! By the time you’re done with this article, you’ll feel a lot better about all the options available to you. If nothing else, just remember that it’s better to make ANY decision to save rather than to save nothing.

529 Plans Are The Best For College Savings

Choosing A 529 Plan

There are two types of 529 plans: College Savings Plans and Prepaid Tuition Plans. This section is going to be covering the College Savings Plan option. You can find my thoughts on Prepaid Tuition Plans later in the article.

The first step of picking your 529 plan is to see if your state offers income tax breaks for using their 529 plan. If they do and their fees are low and they have a good choice of mutual funds, it will make the most sense to stick with your state’s plan.

Contributions aren’t only limited to the state’s residents though. If you live in a state without state 529 plan tax incentives, you may find that New York’s, or any other state’s, 529 plan is a better option. This nifty comparison tool will help you compare 529 plans.

Tip: To save on fees, choose a Direct Sold 529 plan instead of Advisor or Broker sold plans

Contributing To A 529 Plan

The great thing about a 529 plan is that they don’t have an income limit contribution cutoff. This means that anyone can open a 529 plan regardless of how much they earn.

To avoid gift tax consequences, single taxpayers can contribute up to $14k a year or $70k lump sum to count for 5 years.  Married couples can contribute $28k a year or $140k lump sum to cover 5 years of contributions.

Total 529 plan contributions are set by each state. Some go up to $380,000. One great thing is that there isn’t an age limit on usage.

Keep in mind, the money can only be withdrawn without taxes for qualified education expenses that include tuition, room & board, books, and other supplies and fees.  So if there was any leftover money in your child’s 529 plan, you could leave it in the plan to help with future grandkids’ tuitions.

What Are The 529 Plan Options If Your Child Doesn’t Go To College?

This is probably the biggest reason I hear when people mention they aren’t saving money for their child’s college. They don’t want the money to be locked into an account that only allows educational expenses to be paid in case their child doesn’t go to college.

If your child doesn’t go to college, all isn’t lost! There are a few options you can mull over.

Options For A 529 Plan If You Have Leftover Money:

1) Remove The Money From The 529 Plan

The simplest option isn’t always the best.

Money spent on non-qualified expenses is subject to a 10% penalty on earnings in addition to your normal income tax rate on gains.  This isn’t the best way to use the money since it’s heavily taxed but it is an option.

2) Choose A Different Beneficiary

The original beneficiary doesn’t have to be the person who uses the entirety of the 529 plan. The account owner can transfer it to a different sibling or relative. Or they can choose to hold onto it for future grandkids to use.

Can you imagine how many grandkids you could send to college if you left that money to grow for another 20 plus years? That’s a pretty cool legacy to leave for your family.

4) Use Your 529 Plan For Trade School

Not everyone is cut out for the traditional 4-year college experience. Trade schools are becoming more popular. They’re usually 2 years with an apprenticeship at the end. In many trades, the pay is very good and outsource-proof.

If you have a child who would rather become skilled tradespeople rather than attend a 4 year college, check that the program has a Federal School Code so that you can use your 529 funds.

5) Pay For K-12 Education

A recent change in the law now allows 529 plan funds to be used for K-12 education. The restriction is that you can only use it to pay up to $10,000 per year for tuition.  

This is helpful information to know when your child is younger. If your state has a tax deduction, you could filter $10,000 each year through your state’s 529 plan, snag the tax benefit, and pay for private school.

6) Roll The 529 Plan Into An ABLE Account

If your child has become disabled and you had been saving in a 529 plan, you may roll up to $15,000 of it into an ABLE account.

This account is for people disabled before age 26 to save and pay for disability-related expenses but still qualify for government benefits.

7) Win Scholarships

If your child wins a scholarship, you’re able to take out the equivalent amount from the 529 plan without incurring the 10% penalty for unqualified withdrawals.

You’ll still need to pay income taxes on any of the gain amounts though so it may be better to leave the money alone to cover books or board.

529 Plan’s Effect On Financial Aid

Did you know that the government expects you to contribute money towards your child’s college whether you saved or not? The amount may be higher than you expect!

The Free Application For Federal Student Aid (FAFSA) determines the Effective Family Contribution (EFC) which is the amount parents are expected to cover for college every year.  Hop on over to get an idea of how much your EFC may be. That way you can plan now how much you’re aiming to save.

These 529 plans are considered assets of the parents.  No more than 5.64% of parental assets will be expected to cover costs but they factor in 20% of the student’s assets.

Qualified plan withdrawals from a parental owned 529 plan are excluded from federal income tax and don’t have to be reported on next year’s income on the FAFSA.

To run a scenario: If you have $50,000 saved in a parent-owned 529 plan, only $2,820 maximum would be added to the EFC.

This is why it makes more sense to save money instead of trying to make yourself look like you have nothing on the FAFSA.

What About Grandparent Owned 529 Plans?

Grandparentowned 529 plans work a little different on the FAFSA.  The amount withdrawn is added to your base income on the FAFSA for the following year. This makes it look like you made a lot more income and will increase your EFC.

It’s perhaps best to use any grandparent-owned 529 plans the child’s final year of college when you will no longer be filling out the FAFSA.  

You can also look into rolling the grandparent’s 529 plan into yours.  Some states allow a transfer of the plan’s owners without the recapture of the state income tax credits.  

If the grandparents aren’t contributing for tax benefits, it’s easiest for grandparents to contribute directly to the parent-owned plan.

The Remaining College Savings Options

As you can tell, I’m a huge fan of 529 plans. The tax-free growth is amazing. They’re essentially Roth IRAs for college savings but you don’t have to be 59 1/2 to use the money.

The remaining college savings options will work well for certain situations. They aren’t a one-size-fits-all solution by any means. I don’t even necessarily recommend all of these options but wanted to list them to give a complete picture.

1) Coverdell ESA Plans For Education Savings

A Coverdell Education Savings Account (ESA) is very similar to a 529 plan. It uses after-tax dollars and the savings grow tax-free.

The Upside Of An ESA

  • A great benefit of the Education Savings Account is that it is more flexible. You can pay for uniforms, tutors, and other related expenses in K-12 education instead of solely tuition.

ESA Downside

  • You can only contribute $2,000 a year maximum to an ESA. This is a large difference from the $14,000 a year you can contribute to a 529 plan.
  • Also, the contribution eligibility for an ESA phases out if your income is $190,000 or higher.  

Coverdell Education Savings Account Effects On Financial Aid

The effect of money saved in an ESA has the same effect on financial aid as a 529 plan. If the account is in the parent’s name then only 5.64% of the asset amount will be added to the Effective Family Contribution.

2) Roth IRA To Pay For College

The people I’ve heard advocating for this savings method argue that it’s a good option in case their child decides not to go to college.

This way, the parents get to keep the tax-free growth for themselves.

Can A Child Have Their Own Roth IRA?

If your child is earning an income, the equivalent amount earned up to $5,500 can be put into the Roth IRA starting at any age.

Once 18, your child gets to be in charge of the account. This isn’t a good way to save for college because there aren’t withdrawals without penalty until the account holder is 59 ½.

Should You Use Your Own Retirement To Pay For College?

Unless you’re wealthy through other means, you shouldn’t use your own Roth IRA to save for your child’s college, even if you’ll be 59 ½ when they attend.  

If your income is $189,000 for couples ($120,000 individual) you aren’t eligible to contribute directly to a roth IRA.  You could go through the Backdoor Roth loophole of an after tax traditional IRA contribution and roll it immediately to a Roth IRA .

With a Roth IRA, you’re able to take out the principle at any age. As long as you only take out the principle, and not gains, you won’t incur any penalty. You are removing that money from the market though so this will significantly stunt your compounded returns.

You should never sacrifice your retirement savings to pay for a child’s college. Your child can choose a less expensive school to attend or apply to more scholarships.  There aren’t scholarships or loans for retirement.

Roth IRA Effects On Financial Aid

Retirement accounts aren’t considered assets on the FAFSA. Its assets won’t hurt your chances at aid eligibility.    

If you take money out of a Roth IRA to pay for college, that money is reported as untaxed income the following year. This is weighted more heavily on the FAFSA and affects your EFC.

Happy female college students reading book

3) Other Savings Accounts, Money Market Accounts, CDs

Savings accounts, money market accounts, and Certificates of Deposit (CDs) are options banks offer for you to stash money away. The main problem is that the annual percentage yield (APY) is generally pretty low.

If you put college savings into a regular savings account, your money will be losing worth.  Every year inflation goes up 3% so if your money isn’t making at least 3%, it’s technically going down in value.  That same dollar’s buying power is worth less than it was the year prior.

Savings accounts typically have a 1% APY.  Money Market accounts have mid-2% APY. Some CDs have around a 3% APY but they have a 5-year term. If you took out the money from the CD before that term limit was up, you’d lose most of the yield you had earned up to that point.

Savings accounts are great for holding your liquid Emergency Fund but terrible for anything you want to have long term growth.

4) Are UTMA/UGMA Accounts Better Options?

UTMA stands for the Uniform Transfer To Minors Act and UGMA is the Uniform Gift To Minors Act.

Both accounts are custodial accounts that takes advantage of the child’s most likely lower tax rate. (Unless you have a child running a very successful business or a YouTube channel whiz.)

Any type of transfer into the account is permanent. There’s no take-backsies.

The UTMA allows most any kind of asset, including real estate to be transferred to the minor child.

The UGMA mainly allows money gifts such as mutual funds, insurance policies, and balance transfers.

Benefits Of A UTMA/UGMA Account

  • Before the child is 18, their only restrictions are that the money has to be used to benefit the child.
  • In these accounts, the first $1,050 of money is untaxed and the second $1,050 of money is taxed at the child’s tax rate. Typically your child’s tax rate will be significantly lower than the parents’.

Downsides Of A UTMA/UGMA Account

Number 1 Downside

  • There is no reversing of asset transfers! No matter what. No matter if grandma gifted your child $100,000 but now he’s into drugs. No matter if your child ran away and never wants to speak to you again.
  • The child gets full control of the money at age 18 to 21 (depending on the state) so you can’t determine how they spend it. Even if you saved this money for college and they decide they aren’t going to college. Guess what? They get to keep everything in that account.

Another Downside

  • More than $2,100 of income in a UTMA/UGMA is taxed at the higher of the tax rates (parents’ or child’s). With these accounts, you don’t get the benefit of tax-free growth.

UTMA/UGMA Effect On Financial Aid

If the account is in your child’s name, it is counted as their asset. On the FAFSA, a child’s non-retirement assets are assessed at 20% to go towards the EFC.

To get around this, you can set up the account in your own name so it’s counted as a parental asset. This will forego the benefits of being taxed at the child’s income tax rate though.

5) College Education Trust

You’d need to discuss setting up an education trust with your lawyer. Someone would a lot of wealth would consider this option.

The benefits are that you can set up specific guidelines the beneficiaries have to meet in order to get their tuition paid for.

The downside is that the beneficiaries will probably need to pay income tax on any earnings. This would be reported as income on the FAFSA.

Does this matter? Not likely since your chance for getting need-based financial aid when you have an education trust is probably low.

6) Real Estate To Pay For College

This is becoming popular amongst families with investment properties. They say they don’t save specifically for college because they have an investment property earmarked for each child.

Their intention is to give that property to their child when they turn 18. If the child intends to go to college, they’ll need to sell it to pay for school. If they decide college isn’t for them, they now have an investment property to live in or continue to rent out.

Coach Carson has an interesting real estate article describing how he’s doing that for his children.

You’ll have to decide if this is something you’re comfortable with. Real estate investing is less passive than index fund investing so make sure you have researched the market extensively. At this point in my life, real estate investing leverages too much risk for me to feel comfortable jumping in.

7) Is Pre-Paid College Tuition A Good Deal?

The last college savings option I want to discuss is pre-paid tuition. It sounds like a great deal. You’re locking in today’s tuition rates for the future!

How it works is that you pay today’s tuition rate for an in-state public university. You have to know that your child will be attending an in-state university for this to even remotely make sense.

While this sounds like an excellent deal on the surface, let’s run the numbers.

Pre-Paid Tuition Plan Worth In The Future

The 10-year historic rate of college tuition increase has been 5%.  If you had put the money you’re pre-paying into a 529 plan and picked an S&P index fund, your returns would average between 8-10%.  That’s the long term return average for the S&P 500.

If you decided to contribute $200 a month from the time your child was 1 year old to 18 years old, you would have contributed $40,800 in that time period.

If you follow the 5% rate of tuition increase, the growth on that money would be $24,317 for a total of $65,117. This is the estimated worth of the pre-paid college tuition plan by the time your child is 18.

Your contributions are twice as much as the growth you’ll earn in the pre-paid tuition plan. This growth is the amount you’re saving by locking in tuition.

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Worth Of The Same Money In A 529 Plan

If you instead invested the same $200 into a 529 plan with low cost index funds, you’d have a very different picture.

If those index funds got a return rate of 8%, your $40,800 contribution would have a growth of $46,680 bringing the total value to $87,480.

You can see that you’re about 50-50 when it comes to contributions vs growth.

529 plan 8 percent future worth calculation

If the average rate of return was 10%, that same contribution would have a growth of $66,237 bringing the total to $107,037.

If you can get 10% growth then your growth is a little less than twice as much as your contributions. You can see how great tax-free growth is once it gets going.

529 plan 10 percent future worth calculation

By doing the pre-paid tuition, you’re forfeiting between $22,262 – $41,920 in taxfree growth!

What About Other College Costs?

Remember:  The pre-paid tuition plan ONLY covers tuition.  You still need to pay for books and room & board.  

If 5% of the 529 plan growth accounts for the average increase in tuition, then you still have an additional 3-5% growth.  This 3-5% difference in growth in a 529 plan should cover ALL of the college costs for that same in-state school.

Plus, you’re not tied down to only applying to those schools in case an out of state school offers a better scholarship package.  With a prepaid tuition plan, if your child decides to go out of state you’ll get a return on your money but it won’t be the full plan value.

Speaking of scholarships, the amount of an awarded scholarship can be withdrawn from the 529 plan tax-free.  That way, if your child earned a lot of scholarships you aren’t stuck with too much money in the 529 plan.

Overall Best Way To Save

A 529 plan is going to be the best way to save for college for the vast majority of people. It offers the best return on investment compared to the other options.

It has tax free growth and with all of the options, you’ll have no problem finding a plan with the mix of investments you want. Even better if your state offers tax incentives for contributing to your state’s plan.

The other savings options will work better for people in more unique or specific situations. If you’re wanting a quick and simple way to start saving for college, then a 529 plan is the way to go.

Tell me your thoughts on college savings below.

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Steffa Mantilla

Budgeting & Debt Payoff Expert

Steffa is the founder behind Money Tamer. After paying off over $80,000 in debt through budgeting, she now teaches families how to get their own finances in order. Steffa’s background in operant conditioning and behavioral husbandry has given her an understanding of motivation and motivators. She uses this training to help people understand the reasons “why” behind their money behaviors and how to successfully change them. You can learn more about her here.

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