There are a few options to choose from when it comes to saving for your child’s college. Here in America both states and the federal government desire an educated workforce and therefore incentivize people to save for higher education. These accounts may also be beneficial for people pursuing their masters or doctorates. What are the types of accounts out there? What college savings account is the best for your son or daughter? These may be just some of the many questions you have when it comes to preparing for higher education.
The original college savings account is the Coverdell Education Savings Account, also known as an ESA. It has a lot of similarities to IRAs, such as earnings can grow tax-free if used for qualified education expenses. Next up we have 529 plans. A 529 plan is a great way to save for higher education because of the tax benefits and flexibility. The last type of plan is less of a savings plan and more of a way to prepay for college. This is known as prepaid tuition plan. Very few states still offer this type of plan.
The plan was first introduced in the 1997 tax relief plan by Senator Paul Coverdell. There are some tax advantages to the plan. The tax benefit is that earnings can grow tax-free as long as the proceeds are put towards qualified education expenses. There is a contribution limit to ESAs which is $2000 per year, per beneficiary for 2021. If you or your family make too much money, you may not be eligible to make the full or any contribution.
Another benefit to ESAs is that they aren’t limited to using it for college, they can be used for K-12 education expenses. The contributions you make into the account are invested into ETFs or mutual funds similar to an IRA. An important part to remember about this type of account is that the funds have to be depleted before the beneficiary turns 30 years old. Finally, withdrawals not used for qualified education expenses are subject to a 10% penalty.
A 529 plan is another way to save for higher education. The plan is state-sponsored so each state’s 529 plan looks a little different. There are usually tax benefits to them in the same way as the ESA plan. 529 plan earnings aren’t taxed when used for qualified education expenses at the federal level. States will also provide additional tax benefits, but it varies on the state.
In Colorado, you get a tax deduction for every dollar you put in. The Colorado plan only allows for the money to be used for higher education which may include in-state private and public colleges, community colleges, technical schools, and even culinary schools. However, you may not use the money towards K-12 education. Keep in mind this just one example of a state’s 529 plan. Some states may allow 529 plans to be used for K-12 education expenses so it is important to know the specifics for your state.
How your money is invested in a 529 plan will also vary by state. Nonetheless, most states will provide you a few options, including, investing the money in the stock market or putting it in an FDIC insured savings account.
Once more of a common plan, there are now only nine states that still offer this type of plan. With these plans, you are locking in current tuition rates by buying credits that will be used in the future when the child goes to college. A certain amount of credits will provide you a year’s worth of tuition. You can either buy full years at a time or they offer installment plans. With skyrocketing tuition rates this plan is looking more appealing especially if tuition rates keep rising at a fast pace.
Since the great 2008 recession tuition rates on average have accelerated 35% for public tuition and over 70% for private. Prior to 2008 higher education was rising on average 3.5% a year. Prepaid tuition plans pool the money and invest it hoping to grow it more than the rate tuition is rising. This may be why states are dropping these plans because they can’t safely get enough return to keep up with rising college costs and therefore losing money. Most plans do allow for tuition to be used out of state, but they may only cover a portion or charge a penalty. Similar to 529 plans states will offer a tax deduction.
There may not be a single answer to this question as it depends on the individual. The hardest part of life is predicting the future. What you’re trying to decide is what your child will want 15+ years in the future. It is a daunting mental challenge. Ask yourself some questions to help narrow down the options. Do you plan on needing money for K-12 education? Will my child want to go the standard in-state college route or will he/she want to attend a technical school? Do you think tuition rates are going to keep drastically increasing or will they slow down?
Probably the most popular route is the 529 plan. They offer the most flexibility and great tax advantages. You can easily transfer the account to other family members if the child doesn’t go to any higher education. Some 529 plans allow for K-12 uses and others allow trade schools and community colleges. Once again you will want to understand the details of your specific state before choosing.
On the other hand, tuition at both private and public colleges has risen 35% + since the great 2008 recession. The S&P 500, a potential way your 529 plan gets invested, over the last 10 years has returned around 14%. If tuition keeps rising faster than the stock market a pre-paid plan could have its benefit. That is if you can still find one. Not to forget the Coverdell ESA still has its merits, but its popularity may be waning.
Whatever plan you choose you are making a positive impact on your child’s future and often reaping some kind of tax benefit. Once you are ready to implement the plan deliberate how much you can afford to sock away each month. Consider asking relatives to contribute to the plan for the child’s birthday or Christmas. It may be a better investment than the savings bonds your Grandma gave you. Touch base with the best Colorado financial coaches if you still need additional guidance.