You can find the right type of college savings account for your child by answering a few questions.
Types of College Savings Accounts
First of all, it’s important to understand the types of college savings accounts available. Each type of plan comes with its own advantages and disadvantages.
- 529 prepaid tuition plan
- 529 education savings
- Coverdell ESA
- Custodial accounts
As you consider your options, keep in mind that you might find one of these accounts better for your situation than others. It’s also worth noting that you don’t have to limit yourself to one type of account.
What Is Your Risk Tolerance?
If the safety of funds is your primary concern, then find out if your state offers a Section 529 prepaid tuition plan. These state plans let you buy tuition in today’s dollars and get an equivalent amount of money for tuition in the future—sometimes guaranteed by the issuing state. It’s unlikely that these plans will outperform the stock market, but your money will likely be safe.1
The federal government does not guarantee prepaid tuition plans, but some state governments do. However, some states do not guarantee them. To prevent losing some or all of your money, check to make sure your prepaid tuition payments are guaranteed.
If you’re willing to take more risk in exchange for a possible higher rate of return, then you need to determine if your state offers a Section 529 investment tuition plan, also known as an Education Savings Plan. These plans provide you with options from reputable investment firms. If the market rises, your investment will increase accordingly, but it can also decrease if the market suffers a downturn.
With an Education Savings Plan, you normally choose from a menu of investment options offered by the custodian. If you have a lower risk tolerance, you can choose to focus on bond mutual funds and other securities considered “less risky.”
Series EE and Series I treasury bonds have historically lagged behind the Section 529 prepaid tuition plans. Using bond mutual funds in any of the other savings plans may offer an equal historical rate of return, but they are also subject to volatility and potential losses.2
How Much Time Until You Need the Money?
One question to ask yourself as you consider risk tolerance is how long it will be until you need to access the money.
From 1991 to 2021, the average tuition and fees at public four-year schools more than doubled.3 When you consider such a dramatic rise in costs, a Prepaid Tuition plan can make sense, especially if your child is young. By locking in lower rates starting now, it’s possible to build up enough credits before your child attends school.
This also applies if you’re looking at an Education Savings Plan, however. With a longer time frame, you might be able to invest more aggressively at the beginning and later shift the 529’s asset allocation as your child approaches college age.
Consider speaking with a financial professional who can help you develop an approach that works with your risk tolerance and time frame.
|529 Plans: Prepaid Tuition vs. Education Savings|
|Prepaid Tuition||Education Savings|
|Purchase future credits and current prices||Invest money with the potential for growth|
|Limited as to where funds can be used||More flexibility in where the funds can be used|
|Usually can’t be used for room and board||Room and board are qualified expenses|
|Guaranteed plans can protect your money||No guarantees against market events|
|Potential tax benefits||Potential tax benefits|
Where Do You Live?
Many states offer substantial financial incentives for using their in-state Section 529 Savings Plan. Considering that some states essentially put cash back into your pocket for using their plan, it seems wise to take advantage. You might be eligible to receive a deduction or credit on your state income tax return, or your state might actually match your contributions to the plan, up to certain limits, if you are a resident.
Since many states offer at least one or two good long-term stock market options in their savings plans, it’s probably a good move to take the “free money.” Even if you don’t have access to your favorite mutual fund, this initial boost can lift your returns over time.
Since most states’ 529 plans primarily cover public colleges and universities, you might want to consider the Private College 529 Plan if you think your child might attend a private school.
Realize, though, that there are no federal tax benefits for contributions.4 While the money grows tax-free in a college savings account when used for qualified expenses, contributions are made with after-tax dollars. You might get a state tax benefit, but you won’t see that same benefit at the federal level.
Can You Save $2,000 Per Child Per Year?
If you can save more than $2,000 per year, a Section 529 Savings Plan might be your best choice. The only caps placed on contributions to Section 529 savings plans are “lifetime” totals for each child. Parents can contribute to lifetime maximums that range from the low $100,000s to over $300,000. Even better, these sums grow tax-deferred and may be potentially withdrawn tax-free. Tax law changes even allow for 529 money to be used for K-12 expenses under certain circumstances. Best of all, Section 529 accounts allow the assets to remain under a parent or donor’s control forever. They’re even allowed to take the assets back for personal use.5
If you cannot save $2,000 per year, on the other hand, then a Coverdell Education Savings Account (ESA) might be good for you. A Coverdell ESA offers freedom in selecting your investments, as well as much looser standards on how the money gets spent (including tuition for grades K-12). The case for a Coverdell gets even stronger if you have multiple children because you can transfer unused funds to another Coverdell account, or use the funds to set up a new one for other family members, including grandchildren.
Basics of the Coverdell ESA
Here are a few of the basics to keep in mind when choosing a Coverdell ESA:6
- Contributions must be in cash
- Income restrictions for contributions
- An annual cap of $2,000 in contributions
- Money can’t be invested in life insurance contracts
- All of the money in the account must be distributed to the beneficiary within 30 days of them turning 30
- Ability to transfer funds to another Coverdell for a different beneficiary
- Flexibility in using the money for K-12 expenses
What About UGMAs, UTMAs, Roth IRAs, and Trusts?
While these vehicles offer some unique planning opportunities, they will not serve most families as well as Section 529 plans or Coverdell ESAs.
UGMA and UTMA (Uniform Gift to Minors Act and Uniform Transfer to Minors Act) custodial accounts count heavily against financial aid and require the assets to be handed over to a child usually no later than age 21 (may vary by state). Buying individual bonds in a UGMA or UTMA might get you close to the return of prepaid tuition plan, but will be subject to taxation on any interest earned above a certain amount.7
A Coverdell ESA or a Section 529 account offers virtually the same tax benefits as a Roth IRA, without wasting a valuable opportunity to save for your retirement.
Trusts may sound impressive but are extremely expensive to set up and run. Don’t consider one unless you want to exceed the maximum allowable Section 529 Plan contribution limit.
While there are certain situations in which these types of custodial accounts can make sense, for many people, they won’t be as effective as other types of accounts—especially if you’re hoping for need-based financial aid.
Choosing the Best College Savings Account for Your Child
In the end, it’s up to you to do the research and consider your circumstances. Figure out what’s likely to provide the most benefit while offering more options for the future. And, of course, no matter which type of account you choose, the earlier you start saving, the better off your child will be—and the less likely they’ll be to need to use debt to fund their education.
College Fund Account For Baby
Time is on your side (hey, baby-to-be hasn’t even started preschool yet), and most families don’t pay the whole bill themselves. If you’re planning for a family, here’s the lowdown on the best tools to save for college — and grow your money:
These plans are like state-sponsored piggy banks with extras: Your money’s invested and your earnings aren’t taxed.
- They’re hands off. A state agency invests your money in mutual funds and the like. Sign up for automatic deposits and you can practically forget about it.
- You avoid the tax man. As long as you spend the money on such specific college-related expenses as tuition, fees and course materials, you don’t have to pay Uncle Sam on the earnings. Bonus: Your state may also give you a tax break.
- The sky’s the limit (almost). There are some limits to how much you can contribute each year before paying a gift tax.
- You can switch beneficiaries. If your firstborn opts out of the college route, a younger sib can be the recipient without penalty.
- It has little impact on financial aid. A 529 plan is considered your asset, not your child’s, which will help your scholar get more grant money.
- The funds must go toward qualified educational expenses. If not, you pay a 10 percent penalty, plus taxes on the earnings.
- You have limited control. For the most part, someone else manages your money, and typically, you can make changes only twice a year. Plus, if the stock market takes a nosedive, your saving-for-college funds may too.
- There may be enrollment and annual maintenance fees. All this simplicity comes at a cost. Compare the charges of different plans at savingforcollege.com.
Coverdell Education Savings Account (ESA)
You can make tax-free withdrawals from these accounts to pay for college, cut costs during your little learner’s school years or cover other qualified education expenses.
- Again, you avoid the tax man. When your little one goes to pull the money out in 18 years to pay for college, she won’t pay any taxes on it.
- You call the shots. Invest your money any way you want and make changes as often as you like.
- You can use the money for costs besides college. The cash can pay for elementary and/or high-school tuition, after-school programs, textbooks and even tutoring.
- It has little impact on financial aid. As with a 529, a Coverdell is counted as the parent’s asset, so your child will be eligible for more grant money.
- You can switch beneficiaries. You can switch the recipient without penalty as long as it’s a family member under the age of 30.
- You can put in only $2,000 per child per year. Two grand a year won’t get you too far in saving for college, so you need other types of savings too.
- Not everyone can get in on it. If your annual “modified adjusted gross income” (shown on your tax return) is more than $110,000 (for an individual) or $220,000 (if you file a joint return), you’re out of luck.
- There are time limits. You can contribute only until your child is 18, and the money must be used by the time he’s 30 or the remaining amount will be taxed.
The only difference between these accounts and a regular savings account? These are in your child’s name.
- They’re easy. You control these accounts until your child hits adulthood (18 to 25, depending on your state). Set one up at any bank, contribute as much as you want, and take out money anytime to spend on anything as long as it’s being used on your child.
- They have some tax advantages. A portion of the initial investment income isn’t taxed at all.
- They can hurt your chances for financial aid. Because they’re counted as student assets, your child will get less money from the financial-aid office.
- Your child gets all the power at age 18 to 25. You can’t stop him from spending the money on a cherry-red Ferrari. And you can’t switch beneficiaries.
- They’re taxable. You’ll pay Uncle Sam every year (after that initial tax-free investment income).
U.S. Treasury Bonds
If you’re concerned about stock market ups and downs, government savings bonds make saving for college a less risky proposition.
- They’re ultra-safe. Series EE and Series I savings bonds are backed by the U.S. government and immune to stock market drops (unlike 529s).
- They’re cheap. Get one for as little as $25 and buy direct from the government at TreasuryDirect with no broker fees.
- They have some tax advantages. The interest earned is generally exempt from state and local income taxes, and if you use the money for tuition, you can get out of paying federal taxes if you’re under income limits.
- They may not keep up with tuition. No matter how high your interest rate, there’s a chance college costs will rise faster.
- You have to wait at least 12 months to redeem them. You’ll pay a penalty if you need the money back right away.
- If you have paper bonds, you can’t lose them. When the bonds mature, you have to remember where you put them so you can redeem them.
How To Set Up College Fund For Baby
One of the biggest questions many adults have for the educational future of a child in their life is how much they should save for college.
It’s a fair concern.
The costs of higher education rise so rapidly, it’s hard to keep up. The goal you set when a child is born may no longer be enough when they head off to college.
Data shows that from 2001 to 2021, the cost of in-state tuition and fees at a public university has increased 212%. This was, surprisingly, the largest increase, compared to 144% for tuition and fees at private universities and 165% for out-of-state tuition and fees at public universities.
It’s also difficult to estimate college costs because there’s so much that goes into them.
The average cost of in-state tuition is $9,580 per year. But the total cost of attending a public university for a single year is $25,615.
When you add in fees and other costs associated with higher education, the price tag more than doubles. And the total cost of receiving a four-year public university education is currently $103,456.
Most adults likely see these figures and wonder how they could ever save enough to send a child to college.
The good news is that thanks to the investment accounts available today, you don’t have to save it all yourself. As long as you’re contributing to a college fund, compound interest can help your money grow even faster.
If you saved $100 per month in a savings account from the time a child is born until the time they turn 18, you’d end up with roughly $21,800, since the average interest rate of a savings account in the U.S. is only a measly 0.07%.
Unfortunately, that’s not enough to cover even one year of average costs at a public university.
But what if you’d invested that money instead?
If you’d invested that same $100 per month with a 10% annual return (the average, according to the U.S. Securities and Exchange Commission), you’d end up with $55,275.
As you can see, this still isn’t quite enough to cover the entire cost of a degree from a four-year university. But you’re more than halfway there.
And if you can swing an investment of $200 per month, then you’ve fully funded four years at a public university.
When you look at the cost of college as one big number, it’s easy to feel overwhelmed. But when you break it down into a monthly goal, it’s suddenly far more manageable.
When Should You Start Saving for College?
It’s never too soon to start investing in a child’s future, whether that’s saving for a child’s college education, or putting money aside for other life goals.
As we discussed in the previous section, compound interest really helps your money grow as you contribute to a child’s financial freedom and independence.
And the most important component of compound interest? Time.
We’ve already talked about the importance of investing in college rather than just saving for it.
But it’s also important to discuss the value of investing early, rather than waiting until the child is just a few years away.
Let’s say you put your money into an investment account with a 10% annual return.
If you start contributing $100 per month from the time a child is born until the time they turn 18, you will end up with $55,275. And depending on where that child goes to school, it could very well be enough to fund their entire education.
Unfortunately, data shows that most families don’t start saving when a child is born. Instead, the average age a child is when their family starts saving for college is seven.
So what happens when you make that same $100-per-month contribution with a 10% return?
With seven fewer years to save and for that money to compound, you ultimately end up with about $22,523. Your savings have been cut in half just by losing those first seven years.
Now, let’s look at what happens when a family waits until a child starts high school or turns 14 to start saving.
With just four years for your money to grow, you’d have only $5,716 by the time the child heads off to college.
And it’s not simply a matter of putting less into the account.
If you invest $100 per month for 18 years, you ultimately contribute $21,600. If you invested that same amount ($21,600) when your child started high school, you’d still end up with just over $30,000.
It’s not bad, but it’s considerably less than you got by investing the same amount over a longer period.
This math applies no matter what financial goal you’re saving for.
Many adults save for a child’s college education. But the same rule of thumb is relevant no matter what your saving goals. To give a child the gift of financial freedom, the earlier you start, the better.
How to Start a College Fund for a Baby
There are two main savings tools that adults can use to save for the college education of a baby that they love.
529 College Savings Plan
A 529 college savings plan is a tax-advantaged investment vehicle to help save for qualified education expenses.
When you contribute to a 529 plan, your money grows tax-free. And as long as it goes toward educational expenses, you won’t pay taxes on your earnings.
529 plans can be used to pay for most of the costs associated with higher education, including college tuition, fees, textbooks, computers, rent, and more.
Because they’re meant for education expenses, there are some penalties to using that money for anything else.
First, you’ll pay taxes on your earnings. Then, you’ll also pay a 10% penalty on those earnings. That being said, if a child chooses not to attend college, the funds can be transferred to another beneficiary.
The other benefit of the 529 college savings account is that they have a limited impact on financial aid.
Money in a 529 plan account owned by a child’s parents is considered the parents’ asset. Schools only expect parents to use about 5.64% of their own assets to pay for college, compared to 20% of the child’s.
There’s one important exception: 529 plans owned by anyone but the parents, meaning grandparents, godparents, and other loved ones, are considered the children’s assets. As a result, they’ll weigh more heavily against financial aid.
Pros of the 529 plan:
- Tax-free growth on investments
- High contribution limits
- Favorable financial aid treatment
Cons of the 529 plan:
- Limits on what the money can be used for
- Limited investment options
A custodial account is a type of investment account that an adult opens for a child. The adult, known as the custodian, manages the account and makes all the investment decisions. Then, when the child reaches adulthood, they take full control of the account and can use it for anything they wish.
Contributions to custodial accounts are irrevocable gifts. Once they go into the account, they legally belong to the child and can’t be taken back.
Custodial accounts offer significantly more flexibility than 529 plans. First, the child can use the money for anything.
They’re also far more flexible in terms of your investment portfolio.
There are two types of custodial accounts: an UGMA account and an UTMA account.
An UGMA account can hold just about any financial asset, including stocks, bonds, funds, insurance policies, cash, and annuities. An UTMA account can hold all the same types of financial assets, as well as physical assets like real estate.
The downside of these accounts is that they don’t come with tax savings like 529 plans. They also have less favorable treatment for financial aid. Money in a custodial account is the child’s asset, meaning they weigh more heavily against financial aid.
Pros of the custodial account:
- Total flexibility
- No contribution limits
- Many investment options
Cons of the custodial account:
- Fewer tax advantages
- Unfavorable financial aid treatment
If you’re considering opening a custodial account for a child in your life, EarlyBird might be just what you’re looking for.
EarlyBird offers a simple and innovative option for custodial accounts. Any loved one can easily set up an account and then invite other friends and family to invest in the child’s financial future collectively.
The benefits of an EarlyBird account go far beyond saving for a child’s college education. First, gifts to a child’s EarlyBird account have an emotional impact, as you can record a video memory for the child with every donation.
And the money in a custodial account can provide ultimate financial freedom for a child’s future.
Using the 529 Plan and Custodial Account Together
We’ve talked about the pros and cons of both the 529 college savings plan and the custodial account. And you might be wondering how to decide between them. Rather than looking at it as a one-or-the-other situation, consider how you can use the two together.
The 529 plan offers advantages for college savings that a custodial can’t compete with. It comes with incredible tax advantages and reduces a child’s chances of missing out on financial aid. But it does have some shortcomings.
First, 529 plans are designed to be used for qualified higher education expenses.
If a child decides not to attend college and you use the money for something else, they will pay taxes on their earnings, as well as a 10% penalty.
Plus, there are some college-related costs that 529 plans can’t be used for. Those costs include your child’s transportation costs, groceries, and other spending money.
By using the 529 plan and the custodial account together, you’re covering all your bases.
You’re gaining the tax advantages of the 529 plan, as well as planning for those expenses it won’t cover. You’re also covering your bases in case the child decides not to attend college or to at least postpone it for a few years.
A child could use the 529 plan to cover their college expenses, then use the money in their custodial account to start a new life after graduation.
Tips on Saving for College
Saving for college is no small feat. Here are a few other tips to make the process a bit easier.
- Start early: You can’t save for a child’s education all in one day. Instead, it’s about small and consistent action over many years.
- Invite friends and family to join: All of the loved ones in a child’s life will be excited to invest in their financial future. When you open a custodial account through EarlyBird, you can easily invite loved ones to contribute.
- Encourage your teen to get a part-time job: When a child makes an investment in their own future, it means even more to them. Encouraging a teen to get a part-time job and invest some of their money can help increase their college savings and create a greater sense of ownership over their future.
- Apply for scholarships: There are thousands of scholarships available to help young people cover the cost of college. There are merit and need-based scholarships, scholarships for students with particular hobbies and interests, scholarships for students studying a particular subject, and more.
- Student loans: A child going into debt for college isn’t a perfect solution, but sometimes it’s the best option. A student loan can easily help bridge the gap between the cost of college and what a family is able to save.