College Savings Vs Investments: Where Should Your Money Go?

Saving for college is a long-term commitment, and there are several methods to help you get started. The most popular education-specific savings plan is the 529 plan, which comes in two types: an investment savings account and a prepaid tuition plan. The former allows you to invest in mutual funds or exchange-traded funds, while the latter lets you lock in today's tuition rates for future use. Another option is the Coverdell Education Savings Account (ESA), which is similar to a 529 plan but with more investment flexibility and stricter contribution rules. For those seeking a more conservative approach, laddering CDs or savings bonds can be an option, offering some flexibility in terms of cash flow. Alternatively, a Roth IRA can be used as a combination retirement account and educational savings vehicle, providing tax advantages and investment flexibility. Finally, a simple bank savings account can also play a complementary role, offering minimal returns but the benefit of penalty-free withdrawals for any purpose.

529 college savings plans

A 529 college savings plan is a state-sponsored investment plan that enables you to save money for a beneficiary and pay for education expenses. It is a tax-advantaged savings account designed to be used for the beneficiary's education expenses. It is named after the tax code, and its tax benefits make it a popular choice for investing in college.

The account owner maintains ownership of the account until the money is withdrawn. There are no income restrictions on 529 plans, and anyone with a Social Security or Tax ID number can be a beneficiary. The beneficiary can even be the same person who sets up the account.

The main benefit of a 529 plan is its tax advantages. As long as the money stays in the account, no income taxes will be due on earnings. When you take money out to pay for qualified education expenses, those withdrawals may be federal income tax-free and, in many cases, free of state tax too.

There are also no age restrictions, and the account owner always controls the account. If your child doesn't go to college, you can name another eligible family member as a beneficiary, use the funds for your own qualified education expenses, or take a non-qualified withdrawal.

The main downside of a 529 plan is that the cash you invest must be used for education expenses. If it isn't, you'll have to pay a 10% penalty fee plus income taxes on your withdrawals.

When selecting a 529 plan, you should consider any tax breaks your state offers, plan fees and costs, investment choices, and investment minimums for opening and contributing to the account.

Other options for saving for college include brokerage accounts, Roth IRAs, mutual funds, and Coverdell Education Savings Accounts (ESAs). However, these alternatives may not offer the same tax benefits as 529 plans and may have more limitations on contributions and withdrawals.

Education Savings Accounts (ESAs)

ESAs are available in 17 states, including Alabama, Arizona, Arkansas, Florida, Georgia, Indiana, Iowa, Louisiana, Mississippi, Montana, New Hampshire, North Carolina, South Carolina, Tennessee, Utah, West Virginia, and Wyoming. The specific expenses covered and eligibility requirements vary by state. For example, in Arizona, ESAs can be used to cover private school tuition, public transportation to the school of the parent's choice, fees for standardized tests, textbooks, and uniforms. On the other hand, Mississippi places more restrictions on ESA usage, allowing parents to spend only $50 on school supplies and requiring that computers purchased with ESA dollars be donated to a public school or library once the student is done with them.

The amount of funding provided for ESAs also differs by state. Mississippi, for instance, caps awards at $6,779, with annual increases tied to changes in the state's base per-pupil spending. In Arizona, the base amount for the ESA is 90% of the state's per-pupil spending on public schools, which works out to around $6,400.

ESAs are distinct from other forms of state-funded vouchers and tax credits, like 529 and Coverdell savings accounts. While these tax-exempt savings accounts are managed by states but funded by individual account holders, ESAs are both sponsored and funded by the state. Additionally, while school choice vouchers and tax credits must be used for tuition or other expenses at private schools, ESA dollars can be used for a much wider range of expenses, giving parents more freedom to structure their children's education.

In recent years, there has been a growing movement toward universal ESAs, which are available to any student regardless of income, background, or whether they have disabilities. As of March 2023, 11 states have ESA programs, and this number is expected to increase, with around 20 states considering universal ESA programs in their current legislative sessions. However, the concept of giving parents full control over public funds has faced some criticism and opposition, with concerns raised about accountability, the potential for abuse, and the impact on public school funding.

Custodial accounts

Benefits of Custodial Accounts:

• You can take advantage of the gift tax exclusion to fund the account.
• You can control how the money is invested while your child is still a minor.
• There is flexibility in how the money is spent, as long as it is used for the benefit of the child.
• There is no limit to how much you can invest.
• The value of the account is removed from the donor's gross estate.

Drawbacks of Custodial Accounts:

• You can't change the beneficiary of a custodial account once it's established.
• Your child can use the money for anything after reaching a certain age, which may differ from the parent's original intentions.
• Investment income in custodial accounts may trigger the "kiddie tax".
• Custodial accounts can have a heavy impact on financial aid eligibility. Because the money in a custodial account belongs to the child and not the parent, federal financial aid formulas consider 20% of the money available to pay for college.

How to Open and Contribute to a Custodial Account:

You can open a custodial account at most brokerages or financial institutions. The minimum amount to open such an account generally ranges from $500 to $2,000. Anyone can make unlimited contributions to a custodial account once it's open, but contributions over $18,000 per year ($36,000 for a married couple) in 2024 may trigger a gift tax.

High-yield savings accounts

• Barclays Tiered Savings Account: No monthly fees or minimum balance requirements. Offers a tool for setting savings goals.
• SoFi Checking and Savings: A combination of checking and savings account, with an APY of 4.20% on the savings portion. No minimum deposit requirement or monthly maintenance fee.
• CIT Bank Platinum Savings: Pays 4.70% APY on balances of $5,000 or more. Minimum opening deposit is $100. No monthly fee.
• American Express High Yield Savings Account: Competitive yield, $0 monthly fee, and $0 minimum balance requirement.
• Forbright Bank Growth Savings: Competitive yield to help your money grow faster. $0 minimum balance requirement.
• EverBank Performance Savings: Yield is much higher than the average national savings rate. $0 minimum balance requirement.
• Capital One 360 Performance Savings: Earns the same rate on all balances. No minimum deposit requirements or monthly fees. Capital One also offers an interest-earning checking account.
• UFB Portfolio Savings: Yield is much higher than the average national savings rate. $0 minimum balance requirement.

Brokerage accounts

However, brokerage accounts do not offer the same tax benefits as college savings plans. When you sell investments in a brokerage account, you must pay capital gains taxes on any profits.

• Tax benefits: Brokerage accounts are not tax-advantaged, but you may be able to defer or reduce taxes on investment gains depending on how you invest your money. For example, if you invest in stocks that pay dividends, you may be able to defer taxes on those dividends until you sell the stock. Generally, dividends from investments in brokerage accounts are taxed at ordinary income rates, and capital gains tax rates apply when assets are sold at a profit.
• Impact on financial aid: If the parents own the brokerage account, only 5.64% of the assets are counted towards the Expected Family Contribution (EFC). However, if the child owns the account, 20% of the assets are counted towards the EFC.
• Investment options: Brokerage accounts offer a wider variety of investment options than 529 plans. You can invest in individual stocks, bonds, mutual funds, exchange-traded funds (ETFs), and other securities.
• Fees: There are typically fees associated with opening and maintaining a brokerage account. These fees can vary from brokerage to brokerage.
• Withdrawal rules: There are no restrictions on when you can withdraw money from a brokerage account or what you use the funds for. However, you may have to pay income taxes on the earnings.
• Portability: Brokerage accounts are not portable, meaning you cannot transfer your account to another state if you move. However, you can transfer your assets from one brokerage to another.
• Contribution limits: There are no contribution limits for brokerage accounts.
• If your child doesn't go to college: If your child does not go to college, you can use the money for other purposes, such as a down payment on a house, a wedding, or retirement.

Frequently asked questions