Using college savings and applying for scholarships and grants can help limit or even remove the need to take out loans for school. Some of the best ways to save for college include putting money away in a 529 plan or Roth IRA. Read on to learn more about different college savings strategies and the pros and cons of each.
1. 529 Education Savings Plans
A 529 plan is a state-sponsored investment account with tax perks that help families save for school. Money in a 529 savings plan can be invested in many different assets, such as mutual funds and exchange-traded funds (ETFs). The main advantage of 529 plans is investment earnings aren't taxable as long as you use the funds for qualifying education costs. Eligible expenses include the cost of tuition, room and board, transportation or equipment when participating in an apprenticeship or attending a university or trade school.
Pros of 529 Plans
- Possible tax breaks: In some states, contributing to a state-sponsored savings plan qualifies you for a state income tax deduction or credit.
- Funds are transferable: You may be able to change beneficiaries or transfer funds to another 529 savings plan if the original beneficiary decides not to go to school or doesn't use all the money in the account.
Cons of 529 Plans
- Steep penalties for non-education withdrawals: If you use education savings for other expenses, account earnings are subject to income tax and you could get hit with a 10% tax penalty with some exceptions. For example, if the account beneficiary receives a scholarship, you may be able to withdraw money from the education savings account for non-education expenses without penalty, but you will still pay taxes on it.
- Investment restrictions: Your 529 plan may limit you to certain portfolio options, giving you less freedom to choose individual stocks, bonds or ETFs.
2. Roth IRAs
A Roth IRA is a tax-advantaged retirement account designed to help you save for the golden years—but funds may also be used for college. Money in a Roth IRA grows tax-free, and you can withdraw funds before retirement without paying an early withdrawal penalty if the money is used to cover education costs for you, your spouse, your children or your grandchildren. However, you do have to pay income tax on account earnings for education-related withdrawals unless the account owner is age 59½ or older.
Pros of Roth IRAs
- Money left over can be used for retirement: If your children decide not to go to college or you have money remaining after paying for school, you can keep the funds for retirement.
- No tax penalty for education withdrawals: Withdrawing money for college is one of the few reasons you can take money out of a Roth IRA before age 59½ and not incur the 10% early withdrawal penalty.
Cons of Roth IRAs
- Reduced retirement savings: Taking money away from your nest egg to pay for a child's college education could throw off your retirement plans.
- Income and contribution limits: In 2023, your modified adjusted gross income must be below $153,000 if filing single (and $228,000 if filing jointly) to contribute to a Roth IRA. The annual contribution limit is also $6,500 ($7,500 if you're 50 or older).
- Withdrawals can affect financial aid eligibility: Money withdrawn from a Roth IRA could be considered income when filing for financial aid the next school year. This can affect a student's ability to get education assistance in the future.
3. Coverdell Education Savings Accounts
Coverdell education savings accounts are trusts or custodial accounts for education costs you can open for someone under 18 years old or with special needs. You don't have to pay tax on investment earnings when you use cash in the account for qualified education expenses. However, you must have an annual income below a certain threshold to use this type of account, and the maximum you can contribute annually is $2,000 per beneficiary.
Pros of Coverdell Accounts
- Tax perks: Account distributions are not taxable as long as you use the money for education expenses and the withdrawal doesn't exceed your qualified educational expenses.
- The account is transferable: If the account beneficiary doesn't use all of the money for school, it can be transferred to a family member to help them save and pay for college.
Cons of Coverdell Accounts
- Income limits: For 2023, your modified adjusted gross income has to be below $220,000 when filing jointly (or $110,000 for single filers) to contribute to a Coverdell education savings account.
- Age limits: The money must be used or transferred out of the account before the beneficiary turns 30 years old unless they have special needs.
4. Brokerage Accounts
Taxable brokerage accounts don't offer the tax breaks you'd get with education savings accounts, but they do provide greater flexibility since there are no contribution or withdrawal restrictions. The advantage here is you can deposit as much as you want and take money out of the account for any reason without penalty—but you do have to pay tax on earned interest, capital gains and dividends.
Pros of Brokerage Accounts
- Personalized investments: After opening a taxable account, you can invest in a wide range of assets to create your own portfolio. If you want to maximize your potential gains and college is a long way off, for example, you could choose to invest in riskier assets.
- Fewer restrictions: You can deposit money into the account without limits and use the money to cover a child's education or any other coming-of-age expense, like paying for a gap year or helping with a down payment on their first house.
Cons or Brokerage Accounts
- Capital gains tax: Withdrawals from taxable accounts are subject to capital gains tax, which means you have to give Uncle Sam a cut of your investment earnings.
- No annual state tax break: Contributions to a taxable account won't qualify for education savings tax perks like state tax deductions or credits.
5. Savings Accounts
Putting money in a savings account that offers a high annual percentage yield (APY) could be a good option for college savings you plan to access in the near term. Today, APYs for high-yield savings accounts range from 3% to 5%, which could provide you with a decent return on money you plan to use within the next year or two, or the opportunity to grow money further the longer you let it sit in the account.
Pros of Savings Accounts
- Easy to get started: You might already have a savings account you can start using to save for college expenses. If not, it's easy to shop around and open a new account.
- Freedom to use money the way you choose: You can use money in your savings account for any expense without worrying about withdrawal penalties if you don't use the money for education costs.
Cons of Savings Accounts
- No tax breaks: Contributing to a traditional savings account won't qualify you for the same tax incentives available when depositing money into certain education accounts.
- Earnings may be limited: Saving in a traditional savings account might not provide a return as high as investing in the market over an extended period.
Find High-Yield Savings Accounts
Exactly how much you should save for college depends on your income and where you or your child plans to go to school. For example, the cost of attending a two-year college or in-state public school can be significantly lower than an out-of-state or private school.
For the 2022-2023 school year, the average published price for a two-year in-district public school was $3,860, and $10,950 for a public four-year in-state school, according to CollegeBoard data. That's compared with $28,240 for a four-year out-of-state public school and $39,400 for a nonprofit four-year private school.
Starting to save while your kids are young is the ideal strategy because regular contributions and compounding interest over an extended period give your money a better opportunity to grow. However, starting to save even a year or two before college is still worthwhile since having some money stashed away can lessen your reliance on loans.
Be sure to submit the Free Application for Financial Aid (FAFSA) to see what financial aid you may qualify for. Completing the FAFSA helps you find out if you're eligible for financial aid like grants and government-backed student loans. From there, you could explore private student loans to cover remaining expenses.
The Bottom Line
Putting even small amounts of cash away for college can reduce the amount of money you need to borrow to get an education. And if you're unsure which type of savings account would provide the best tax advantages for your family, consider scheduling an appointment with a financial advisor to discuss college planning.