What Are the Best Ways to Save for College?

By the time today’s crop of toddlers steps foot on a college campus, they could be paying half a million dollars to receive that diploma. That’s why it’s never too soon to start planning a college savings strategy if you want to help your kids with higher education costs.

You’ll find there are several options available to help you save, but what’s the best one? The answer is that there is no right answer, it all depends on your financial situation and the amount of flexibility you want with your savings. Here’s what you need to know about three of the most popular ways to save for a college education.

THE 529 PLAN

A 529 plan comes in two basic varieties.

529 Prepaid Tuition Plan. This straightforward plan allows you to purchase college credits today that can be used in the future at a state school. In other words, it allows you to lock in tuition costs at today’s rates. Generally, you or the child attending college will need to be a resident to participate in a state’s prepaid tuition plan.

529 College Savings Plan. This is the more popular type of 529. You make contributions to the plan and can choose from a variety of investment options that have the potential to grow and compound for many years before you begin making withdrawals.

The beauty of a 529 college savings plan over traditional savings is the tax break. If you use the funds for qualified educational expenses, you’ll enjoy tax-free growth as well as tax-free withdrawals — that includes federal and most state taxes.

And until recently, those educational expenses were limited to college costs, but changes in federal legislation now allow Americans to withdraw up to $10,000 annually to help pay for grade school or high school tuition costs.

Any adult can open a 529 plan, and the owner of the account has ultimate control over the funds. Therefore, you’re free to change the beneficiary on the plan to yourself or any other qualifying family member.

Lifetime contribution limits for 529 plans are high — typically $235,000 to $520,000, depending on the plan you choose. Each state offers its own plan, and you can choose to participate in any state’s plan. (Your own state may, however, offer you specific incentives to choose its plan, including potential tax deductions.)

Watch out for withdrawals that aren’t used for qualified educational expenses. Any such distribution you take will be subject not only to regular income tax but also a 10 percent penalty on your gains.

THE COVERDELL EDUCATION SAVINGS ACCOUNT

The Coverdell Educational Savings Account (ESA) is a different kind of college savings account that you can open through a brokerage firm, bank, credit union or other financial institution.

Once you contribute, you can choose from a wider variety of investments than you’d find in a 529 plan — including stocks, bonds, mutual funds, ETFs, CDs and more. You’re also permitted to switch up investments in your Coverdell ESA portfolio as often as you wish. (With a 529 plan, you’re limited to just two investment changes each year.)

While a 529 plan allows you to withdraw funds for grade school and high school tuition costs, a Coverdell ESA permits withdrawals for any qualified expense at these grade levels, including tuition, books, uniforms, supplies, etc.

And, as with a 529 plan, a Coverdell ESA offers special tax perks. While there’s no tax deduction for contributions, you’ll typically avoid taxes on funds you withdraw for qualified educational expenses. Using money for nonqualified expenses, however, will get you hit with the same 10 percent penalty and tax bill that applies to nonqualified withdrawals from a 529 plan.

Unlike a 529 plan, the Coverdell ESA caps contributions at just $2,000 a year per beneficiary. Additionally, your ability to use it is limited by your income. And, finally, your beneficiary must use the Coverdell ESA’s assets by age 30 — you’re free, however, to change beneficiaries or roll the funds into a 529 plan.

THE UGMA OR UTMA ACCOUNT

The Uniform Gifts to Minors Act (UGMA) account or Uniform Transfers to Minors Act (UTMA) account isn’t specifically designed for college savings, but both offer some unique qualities that may make them appealing for that goal.

Any adult can open a UGMA or UTMA account. Check with your brokerage firm, bank, or credit union to initiate the process. The account is structured so that assets in it are the property of a named minor, with an adult custodian managing the funds until that child reaches adulthood.

The advantage of a UGMA/UTMA is that the assets in the account can be used for anything. There’s zero penalty for withdrawing funds for non-educational expenses, but the account’s assets may only be used to benefit the minor named on it.

Unlike with a 529 plan or Coverdell ESA, there are no tax breaks involved. The assets in the account are also the property of the minor, not the custodian, which makes them irrevocable. Lastly, the minor has total control over the account assets after he or she reaches a certain age (which can range from 18 to 25, depending on the state).

Finally, since the UGMA/UTMA assets belong to the minor, they’re weighed more heavily than parental assets when it comes to financial aid. Keep in mind that your Expected Family Contribution value, as determined by the information you provide on the FAFSA, will likely be greater when you save in a UGMA/UTMA in lieu of a 529 plan or Coverdell ESA.