Saving for college is an intimidating task. On top of the constantly rising costs, choosing the right type of savings account can be confusing.

This article will get into the tax benefits, flexibility, and financial aid impact of a couple of the best options. But there are a few things you should consider before you start saving.

Make sure you’re saving enough for retirement and your other long term goals before you consider setting aside money for college.

You have options when it comes to paying for college – scholarships, financial aid, loans, etc. But there are no loans or scholarships to fund your retirement. So it’s critical that you focus on funding your own goals first.

Once you’re comfortable with what you’re saving for your long term goals, you need to consider how much you want to save for your children’s education. 

Some parents want to cover 100% of the cost. Others want their children to fund some of their own education while still helping to make sure they don’t graduate with a pile of debt.

There is no right answer, but it’s important to clarify what your goal is.

When you’ve decided that you have additional money to save and how much you want to set aside, it’s time to weigh the pros and cons of the saving and investment options available to you.

529 College Savings Plans

The Tax Benefits

529 plans provide the best tax benefits for college savings. The money grows tax free and can be withdrawn tax free if used for qualified education expenses. For example, if you invest $10,000 in a 529 plan and it grows to $15,000, you could withdraw the full $15,000 without any taxes on the earnings.

Some states also offer a state tax deduction as a savings incentive. When choosing a plan, first look at your own state’s plan if a deduction is available.

Another benefit of 529 plans is the 5 year gift tax averaging rule. This allows you to contribute five times the normal annual gift tax exemption in a single year. Typically, you can only contribute up to the annual exemption ($17,000 for 2023) before you begin reducing your lifetime gift tax exemption. 

This means that instead of contributing $17,000 for each of the next 5 years, you could make up to an $85,000 contribution this year with no tax consequences. This can be a huge benefit – the more time you give the savings to grow, the more you save on taxes when you make those tax free withdrawals.

Flexibility

If you don’t use the funds in a 529 plan for qualified education expenses, you will pay a 10% penalty and income taxes on the earnings. But there are a number of features that make a 529 plan a flexible choice for college savings:

The beneficiary of the plan can be changed at any time. There are rules about who the beneficiary can be changed to. But if you have one child who doesn’t end up going to college, you can make another one of your children (or even yourself) the new beneficiary.

There are no penalties if your child receives a scholarship. Funds can be withdrawn from the 529 plan up to the scholarship amount without paying penalties. You only pay taxes on the earnings.

The funds can be used for up to $10,000 per year per beneficiary of K-12 private school education costs. Although, the longer you leave the money in the plan, the more opportunity for tax free growth – so the accounts are best suited for college costs.

You can use a 529 plan to pay student loans. You can withdraw up to $10,000 tax and penalty free to pay down a student loan balance. The $10,000 limit is a lifetime limit per beneficiary.

Financial Aid Impact

529 plans are considered an asset of the parents if a parent is the owner of the plan. This means that only up to 5.64% of the account value is counted against your expected family contribution. This is much more favorable treatment than the 20% used for student owned assets.

The Bottom Line

The tax benefits and flexibility of 529 plans make them the best option for college savings if you are fairly certain your child will go to college. And if they don’t, you can always use the funds for a sibling or your future grandkids. Worst case, you can take the money out and pay the 10% penalty on the earnings.

Taxable Investment Accounts

The Tax Benefits

While there are no tax benefits specific to college savings, you will only pay capital gains taxes as opposed to (typically higher rate) ordinary income taxes on any earnings within these accounts. However, the real benefit in using a taxable investment account is the flexibility.

Flexibility

Savings in a taxable investment account can be used for any purpose. These accounts provide the ultimate flexibility. You don’t need to worry about changing beneficiaries or paying any penalties if your child doesn’t end up going to college.

You can also invest in just about anything you’d like within these accounts. This gives them a slight leg up on 529 plans which have limited investment options. Although the best 529 plans do have good low cost and well diversified options that are more than sufficient.

Financial Aid Impact

Taxable investment accounts are treated as an asset of the parents, similar to 529 plans.

You do need to be careful if your child has a custodial account, often referred to as an UGMA or UTMA account. These are considered the student’s assets which is less ideal from a financial aid standpoint.

If your child is receiving a cash gift from a family member to be used for college expenses, you’re likely better off putting it into a 529 plan instead of a custodial account if you anticipate receiving any financial aid.

If your child already has a custodial account, you can consider transferring those funds to a custodial 529 account where they will count as the parents assets and be less impactful to your financial aid award. Just beware of potential tax consequences because you need to sell the investments within the account before moving them over.

The Bottom Line

Taxable investment accounts are the best option if you are not sure that your child will go to college. They offer the most flexibility, despite missing out on some of the potential tax benefits of the 529.

Other Common College Savings Options

Roth IRA

You can use money from a Roth IRA to pay qualified education expenses and avoid the 10% early withdrawal penalty. But these accounts are much better suited for retirement savings. 

Earnings on withdrawals are still taxed if you withdraw the money before age 59 ½ so you are losing the number one benefit of putting the money into a Roth IRA to begin with. Using a Roth IRA should be more of a last resort option.

Coverdell ESA

Coverdell Education Savings Accounts used to be the best way to save tax efficiently for K-12 education costs. But these accounts have become less valuable now that you can save for pre-college costs in a 529 plan. 

There are also some significant restrictions to these accounts. There is a $2,000 annual contribution limit, you cannot change the beneficiary, and you can’t contribute at all if your income is too high. Overall, 529 plans have become a superior savings tool.

Savings Accounts

This is a safe place to store your savings, but cash in the bank will not keep up with inflation. And with the cost of college rising rapidly, you should look to other places to save for these expenses. Investing the money is the best way to ensure you’re not losing value in the long run.

Closing Thoughts

529 plans are the best option for most families looking to save for their children’s future college expenses. If you’re looking for more flexibility, a taxable investment account can be useful. 

Most importantly, make sure you are taking care of your own savings goals before putting money aside for college.

Joe Calvetti is a CPA and the founder of Still River Financial Planning, a comprehensive, fee-only financial planning firm that specializes in working with young families and professionals. Click here to learn more about how we work with clients.

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Disclaimer: The information provided above is for educational purposes only and should not be considered financial, legal, or tax advice. You should consult with a professional for advice specific to your situation.