We all understand the importance of college and want to set our children up to receive the best education possible. However, we also know how expensive the cost of college can be and with cost increasing at a rate of 6% a year, it’s only getting more expensive by the day. This leads to the often asked questions “What’s the best way to save for college”.
Before I answer this question, let’s first list out the various ways in which you can save for college and each of their beneficial characteristics.
Coverdell ESA
Allows you to invest with after tax funds and your investments grow tax free remain tax free if used for qualified education expenses
Allows you to contribute $2,000 per year (per income limits)
Allows you to pick your specific investments
Can transfer from child to child
Can use for more than just college cost (K-12 tuition, tutoring, special needs education)
529 Plan
Allows you to invest with after tax funds and your investments grow tax free remain tax free if used for qualified education expenses
Some states give tax deduction
Contribute as much as you want
Can transfer from child to child
Friends and family can contribute
These two type of college savings plans have some common characteristic but some key differences. The Coverdell gives you a lot more investing options and allows you to use the funds for a wider range of qualified expenses. The 529 plan allows you to save a lot more for college and has no income limits to contribute. 529 plans also give you the ability to receive state tax deductions in some states which can be huge over a 18 year period. So… which plan is best for you? In my opinion, 529 plans seem to benefit families more than Coverdell ESA because they have no contribution limits nor income restrictions. However, Coverdell’s do prove beneficial to those who plan to spend the funds K-12 expenses. What most people don’t consider is that you can do BOTH! A great strategy is to put the first $2,000 into a Coverdell and any extra into a 529 plan so that you can have the best of both worlds.
Now that we have spoken about the pros of these two college savings plans, let’s talk about their one HUGE flaw. If these funds are not used for qualified education expense, not only will they be taxed at ordinary income rates on the earnings but you will get hit with an additional 10% penalty! For those who are in the highest tax bracket (39.6%) you will be looking at a 50% cut in your earnings. WOAH! This breeds a huge concern and leaves a lot of uncertainty in investors’ minds. Will my kid have to pay for college? What if they get a scholarship? What if they don’t attend college at all? Should I even bother saving? These are all great questions and reason for concern when saving for college. But fret not, there happens to be other methods of saving that you probably never considered.
Roth IRA & Taxable Accounts
Many individuals never think to use Roth IRA’s or their brokerage account to save for college, but these can be tremendous saving vehicles for college funding. How exactly do they work you may ask? Well when saving for college in Roth, you are able to contribute after tax dollars and have the earnings accumulate tax free. Also, these funds can be withdrawn for education expenses without the penalty prior to age 59 ½ . Furthermore, if your child decides not to go to college you can use this money to fund your retirement! The same holds true for Taxable accounts! This is an excellent strategy to hedge the risk of your child not attending college or not having to pay for college. Yes, you would still have to pay some taxes on the earnings but not to the extreme of a 10% penalty and ordinary income taxes as we mentioned in the scenario above.
My Ultimate College Saving Strategy
Now that we have discussed all the college savings vehicle out there, I want to give my ultimate college saving recommendation. When saving for college my advice is to save 2 years’ worth of college cost in 529 plans and the rest in a Roth IRA or taxable account. Using this strategy, you can successfully hedge your bets on your kid going to college or not. If they do, 2 years will be funded tax free and the other two you will pay some tax. If they don’t, you will pay taxes and penalties on half the funds accumulated and the other half will grow tax free for your retirement! Of course, there is no one size fits all saving strategy when it comes to college funding but I’ve found this strategy to be extremely helpful for clients who want to minimize their risk of uncertainty.