Ask Stacy — What’s the Best Way to Save for My Kid’s College?

College Students
Photo by Nejron Photo / Shutterstock.com

According to the College Board, for the 2016-17 school year the average cost for out-of-state tuition and fees at public four-year colleges was $24,930, with an average cost for in-state tuition and fees of $9,650. For private nonprofit schools, the cost was $33,480 for 2016-17.

Although the published sticker prices for college often exceed the prices students actually pay, there’s no doubt that sending a kid to college is an expensive proposition.

Here’s this week’s reader question:

I want to start a college fund for my son. Can you tell me how to go about doing it and which college fund would be the best one to start? — Robert

Before we get to Robert’s question, here’s a video I did a while back about how to finance college without borrowing. It could come in handy someday for Robert and his son.

Now let’s get to Robert’s question. The following is a list of the best ways to fund a college education. We’ll start with 529 plans (named for the section of the IRS code allowing them), then move on to other ideas.

529 plans

When saving for college, 529 plans are a great way to do it for the same reason your 401(k) plan is a great way to save for retirement. Namely, the savings on your income tax. Like a qualified retirement plan, earnings in these plans grow federally tax-free.

Virtually every state, along with the District of Columbia, offers some type of 529 plan, either a college savings plan, prepaid tuition plan, or both.

Unlike your 401(k) at work, there’s no federal tax deduction for 529 contributions. But two-thirds of states offer a state tax deduction for residents using their state’s plan, and according to SavingForCollege.com, five states — Arizona, Kansas, Missouri, Montana and Pennsylvania — offer a tax break for any state’s plan. You can see what your state offers with this handy chart from FinAid.org.

There are two varieties of 529 plans: college savings plans and prepaid tuition plans. Let’s explore them both, starting with college savings plans.

College savings plans

These plans are similar to a work-related retirement plan, like a 401(k). You put in as much as you’re allowed, choose an investment option, then hope your contributions earn enough to meet your needs when college rolls around. Earnings are tax-free if used for any qualified college expense, including tuition, fees and room and board. If one kid ends up skipping college, you can substitute a sibling, or even use the money yourself if you go back to school.

Potential drawbacks: If you end up not using the money you put away in a 529 plan, you won’t lose it. But you will pay a 10 percent penalty and income taxes on the earnings (not the principal) for any non-education withdrawal. So you want to be fairly sure someone in the family will ultimately hit the ivory halls.

Another potential drawback is that these plans also aren’t terrifically flexible. Investment options are limited and typically can only be changed or transferred to another plan once yearly.

What to look for: If you live in a state with income taxes, you’ll obviously want to use your state’s plan if it offers a state tax deduction. If you’re able to shop around among various states, however, look for plans with low expenses. As with your 401(k), low expenses mean higher earnings.

Vanguard offers a calculator that will quickly let you know if your state offers a tax deduction and how much that deduction will be based on your contributions and income. Another place to see state deductions is this page of FinAid.org.

Who has the best plan? There are several places you can go to search for the best-performing and lowest-cost college savings plans. Consumer expert Clark Howard lists his favorites here. SavingForCollege has a list of favorites and a comparison tool here and they have a ranking of plans here. Morningstar’s rankings can be found here and FinAid.org’s here.

If you’re expecting everyone judging these plans to agree on the best, you’ll be disappointed. They don’t. Still, you might find a plan or two that crop up on more than one ranking.

Prepaid tuition plans

As with an IRA or 401(k), a college savings account is simply a tax-advantaged place to accumulate money for a specific purpose. Also like retirement plans, there’s no guarantee that when the date arrives to use those savings that they’ll be enough to cover the costs.

A prepaid tuition program seeks to eliminate that doubt by guaranteeing that if you deposit today’s tuition, it will pay the future tuition, no matter what happens inflation-wise.

There are two types of prepaid tuition plans: those offered by states, designed to pay the tuition of in-state public universities, and those offered by private colleges.

When it comes to state plans, the guarantee might not deliver what it implies. Some states limit their guarantee, and others have additional caveats. You can read about them at this page of FinAid.org.

State plans are designed to pay the tuition for public schools within a specific state. If your student later decides to go to a private or out-of-state school, they’ll still pay out, but only the amount they would have paid to attend whatever in-state public college you originally applied for.

Because state plans transfer the risk of inflation from the saver to the state, they’re not nearly as common as college savings plans. While they were more plentiful years ago, these days there are only about a dozen left. Check this page of FinAid.org to see what states offer them.

The news is better for those interested in private university prepaid tuition plans. There are tons of them. Check them out at this page of PrivateCollege529.com.

Coverdell education savings accounts

If a college savings account resembles a 401(k), a Coverdell account is more like an IRA. Up to $2,000 annually can be deposited for each child younger than 18. (This means collectively. If you contribute the full $2,000, Grandma can’t contribute anything.)

As with a 529, your money grows tax-deferred and can be withdrawn tax-free for educational purposes. Also similar is that if you take money out for non-qualified expenses, you’ll pay income taxes and a 10 percent penalty on the earnings withdrawn.

In some ways, Coverdells are more flexible than 529s because they can be used for elementary and high schools as well as for college. They also allow for more investment flexibility. As with an IRA, you can theoretically buy individual stocks rather than just funds.

But they also have some restrictions 529s don’t. In addition to the $2,000 cap per child per year, there are income restrictions. According to the IRS, the amount you can contribute starts phasing out when your modified adjusted gross income exceeds $95,000 for single filers, $190,000 for joint filers, and goes away completely when you reach $110,000 for single filers, $220,000 for joint filers.

When you deposit money into a Coverdell, it ultimately becomes the property of the beneficiary. In other words, when withdrawal time comes along, checks will be cut to them, not you.

SavingForCollege.com has a nice summary of Coverdell accounts here. They also include a list of potential providers.

Roth IRAs

As you may be aware, a Roth IRA is a retirement account that doesn’t offer a deduction when you contribute, but allows for tax-free withdrawals when you reach retirement age.

What does this have to do with funding an education? Another provision of these accounts is that you can withdraw your original investment before retirement age without incurring a penalty. To understand how this could help with college, consider this example from Forbes:

Suppose you started the Roth when your child was born and contributed $5,500 each year for 18 years. Your total contributions would have been $99,000. But, the account value if we presume a net 8 percent return would have grown to $205,976.34.

Roth rules allow you to withdraw your original $99,000 to pay for your kid’s education (or anything else) without penalty. You could then leave the remaining money in the account to accumulate for your retirement.

One potential drawback: For tax year 2017, you can only contribute the maximum to a Roth if your modified adjusted gross income is less than $118,000 for single filers and $186,000 for joint filers. Above that, there’s a phaseout, which you can read more about at this page of IRS.gov.

Which is best?

When it comes to which of these options is best, there’s no correct answer. Each has advantages and drawbacks. What’s best depends on factors including where you live, your income and your ability to save. Of course, you’re not confined to just one approach. If you can meet the various requirements, use more than one.

No matter what you decide, however, the most important thing you can do is start early and make your contributions automatic. That’s the way to both increase your odds of saving enough and getting there as painlessly as possible.

Got a question you’d like answered?

You can ask a question simply by hitting “reply” to our email newsletter. If you’re not subscribed, fix that right now by clicking here.

The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

About me

I founded Money Talks News in 1991. I’m a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.

Got more money questions? Browse lots more Ask Stacy answers here.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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