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Choosing the Right College Savings Plan for Your Child
Choosing the right college savings account for your child could help them afford their dream school.
College can be an exciting time. But with the average undergraduate student borrowing $40,681 to finance their bachelor’s degree, affording college may add to their stress load (and yours).1 That’s why building a college fund could make a huge difference in helping your child afford college without having to take on as much debt just to graduate.
There are several saving options that may help you prepare for your child’s future. This includes common college-specific accounts like 529 plans and Coverdell education savings accounts as well as alternative options, like high-yield savings accounts or brokerage accounts.
With so many options to choose from, picking the right plan is tough. Let’s look at your options to help you decide on the best plan for your child’s needs.
This information is not tax or investment advice. You should consult with a tax advisor and/or a qualified investment professional for advice specific to your particular circumstances.
Key Takeaways
College savings accounts may help you set aside money for your child’s future.
Some accounts restrict how money is used, limiting it to education-related expenses only.
You may choose to have more than one type of account to save for college.
College Saving Fund Options
Choosing the right fund or combination of funds could make a huge difference in how much money you have saved up for your child’s education. Let’s dig into some of the most common college saving accounts.
529 Plans
529 savings plans are probably what you think of when someone mentions a college savings.
Funds in a 529 account are invested in the stock market, and each plan offers its own investment options. The plan often includes mutual funds, exchange-traded fund (ETF) portfolios, and target-date portfolios with the idea that the plan owner directs the investments according to their personal risk tolerance.
As with any investment, your returns aren’t as stable like with a traditional savings account, so it’s important to remember that your child’s educational savings may rise and fall with market performance.
529 plans offer a unique tax benefit: federal taxes aren’t owed on disbursements, provided those disbursements are used to pay for qualifying education expenses.2 Additionally, some states allow you to deduct your contributions from your state income tax liability.3
Disbursements from 529’s may be used for education and living expenses during undergraduate and post-graduate years.4 And up to $10,000 may be used for tuition expenses at elementary or secondary schools.5 If your child doesn’t use the funds, you’re able to change the beneficiary to another person or roll leftover funds into a Roth IRA account.6
It’s worth noting that there are contribution limits on these accounts depending on your state’s regulations.7 If you have questions about 529s, consult a financial or tax advisor for more information.
Custodial Accounts
Custodial accounts are savings or investment accounts opened and managed by an adult on a child’s behalf. Some custodial accounts, like Coverdell education savings accounts, only allow the funds to be used for college expenses. Others, like Uniform Gifts to Minors Act and Uniform Transfer to Minors Act accounts, have fewer restrictions on how assets are used.
The adult is responsible for all aspects of managing the account, from overseeing contributions and deposits to picking investments (as applicable) until the child becomes an adult.
Additionally, some custodial accounts require the child’s parents or guardians to file a tax return on the child’s behalf. If the account’s earnings exceed a certain threshold, the child may owe the “Kiddie Tax.”8 This tax is typically lower than other income tax rates, but it could have a significant impact on the child’s tax liability if the account’s earnings are high.
Custodial accounts may also impact a child’s financial aid eligibility. While 87.3% of students qualify for at least some financial aid,9 the Free Application for Federal Student Aid (FAFSA) calculations factor a portion of the money in custodial accounts into a person’s financial aid eligibility.10 Twenty percent of the value of a custodial account is considered as part of the FAFSA process. 529 plans receive more favorable treatment when it comes to the FAFSA as only a max of 5.64% of a 529 plan’s value is considered.11
High-Yield Savings Opportunities
A high-yield savings account could be a very flexible way to save for your child’s future, whether it includes college or not.
When you open a savings account, there are no restrictions on how you could use the money. This means you’re free to open one for your child’s education fund or any other savings goal you have in mind. Even better, your child may use the funds for any purpose if they decide not to go to college, and having this money on hand could help set them up for a healthy financial future.
When choosing a savings account, look for one with a competitive rate (hence the name “high-yield”) that may help your savings grow faster over time.
The type of account or accounts you choose to open may depend on how long you have before your child leaves for college. If they won’t be attending for a few years, you may want to consider opening a certificate of deposit (CD). These accounts typically offer higher rates than other savings accounts in exchange for locking your money away for a set term.
Keep in mind that FDIC insurance only protects up to $250,000 per depositor, per ownership type, per financial institution.12 If you’re planning on saving more than $250,000, you may want to open an additional savings account at a different bank or under a different ownership type to access additional FDIC insurance.
IRAs and 401(k)s
You may not realize this, but you are allowed to withdraw funds from traditional and Roth 401(k)s as well as IRAs to pay for college without having to pay an early withdrawal penalty. Distributions from retirement accounts are usually subject to a 10% early withdrawal penalty for disbursements taken before 59 ½ years of age. However, education expenses are an exception to this rule, allowing contributions to be withdrawn early and penalty-free.13
It's always important to speak with your tax and financial advisors to get the full scoop, but here are some key considerations to keep in mind.
Money taken from traditional accounts is still subject to income taxes, whereas funds from Roth accounts aren’t subject to income tax because those contributions were made with after-tax dollars. That’s why it’s usually more advantageous to use Roth accounts if you have them.
Whether you choose to take funds from a traditional or Roth retirement account, you are only able to withdraw contributions, not earnings.
Taking money out of your retirement accounts means that you could set back the growth trajectory of your retirement savings.
Also keep in mind that using funds from IRAs may impact the student’s financial aid and eligibility.14 If receiving financial aid is an important component of affording college, be sure to understand the financial aid rules thoroughly before taking any action.
Brokerage Accounts
Many families choose to invest directly in the stock market to save and potentially earn college funds, and they do so with a brokerage account.
When you open a brokerage account, you direct how your money is invested and may use the funds without restriction. But unlike certain college savings accounts, such as 529s, brokerage accounts don’t offer tax-free withdrawals for education expenses.
It’s also worth noting that brokerage accounts may also impact your child’s financial aid eligibility and could influence how much aid they receive.15 Again, familiarize yourself with financial aid rules if financial aid is part of your overall plan for paying for college.
Comparing Your College Savings Options
The 529 Plan | Coverdell Education Savings Accounts | Custodial Savings Accounts | Roth IRAs | High-Yield Savings Accounts | Brokerage Accounts | |
|---|---|---|---|---|---|---|
Pros | Offers tax-free disbursements Contributions may be tax deductible | More diverse investment options than 529s | No restriction on how money could be used | No early withdrawal penalty for education expenses | No restriction on how money could be used | Control over investments |
Cons | Must be used on qualifying education expenses | Contributions are not tax deductible Low contribution limits | High impact on financial aid eligibility | Impacts retirement savings | Rate of return may be lower than investments | May impact financial aid eligibility |
Contribution Limits | Between $230,000 and $550,000, depending on the state | $2,000 per child per year | None | In 2024, $7,000 - $8,000 depending on age16 | None | None |
Which College Savings Fund or Method Is Right for You?
Any of these college savings options could help you set money aside for your child’s education, but one account may work better for your needs than the others. Before you start, consider the following factors.
Your risk tolerance: Investment accounts are subject to market performance. Consider how much risk you’re comfortable with before you open an account. The amount of time your account has to absorb market risk may also be a factor.
Your child’s age: The younger your child is, the more time you have to contribute to the account. Consider the contribution limits each account has and how much you’re able to contribute each year until your child goes to college.
The tax implications: Some accounts have tax-free disbursements while others don’t. Consider how those tax implications could impact your finances.
Your financial aid needs: Custodial accounts, regular savings accounts, and brokerage accounts could impact your child’s financial aid eligibility. Consider whether your child may need to apply for financial aid and how much they’re likely to need before you open an account.
Flexibility of the funds: Many college-specific savings accounts restrict how your child may use the money. Before you open an account, consider if you think your child is likely to go to college or may need more flexibility with the money.
You may want to use more than one approach. Having a combination of accounts could give you more flexibility and may help you save more in the long run.
If you’re not sure what the right choice is for your child, consider consulting with a tax professional or financial advisor. They’ll be able to help you choose the right options.
Final Thoughts
Paying for college may seem daunting, but choosing the right savings methods for your family could give you some peace of mind for the future. No matter which plan you choose, getting started today may help your child reach their educational goals without going deep into debt.
Psst…did you know that Jenius Bank offers high-yield savings accounts? Learn more about these accounts and open one today.