College Savings Plans Explained
An aggregate, college tuition has risen an astonishing 79.5% in the last decade ― nearly twice the growth rate of medical care during the same period and almost three times the increase of the general consumer price index. Textbook prices have also increased by a similar margin between 2003-04 and 2013-14. According to CollegeBoard, the average undergraduate in the United States paid the following tuition and fees during the 2013-14 year:
- Public two-year (in-state): $10,730
- Public four-year (in-state): $18,391
- Public four-year (out-of-state): $31,701
- Private nonprofit four-year: $40,917
- For-profit (tuition only): $15,130
In order to afford such high costs, prospective students and their parents need to begin a manageable college savings plan. Before we discuss the details of the different savings vehicles available to parents, there are a few important college saving tips to keep in mind:
- College savings accounts can be opened before a child is a born. If you are planning on growing your family, it is never too early to start thinking about college.
- Families with multiple children should open separate accounts for each child
- Experts recommend saving at least $400 per month to from birth through graduation to be able to comfortably afford all college expenses.
- You don’t have to choose one type of account; you can mix and match them in a way that suits your income level.
- Don’t be afraid to ask family and friends to gift money into these accounts in lieu of other presents on special occasions.
Saving for college can feel overwhelming, especially with all the different options to choose from. Here, we’ll discuss the best plans for families who would like to start saving for higher education. Remember, the only poor choice you can make when it comes to thinking about college tuition is not saving at all.
529 College Savings Plan
529 plans are highly popular and often recommended by financial advisors. Also known as a “qualified tuition plan,” they offer four major benefits:
- The ability to control the account and change the beneficiary
- Earning are tax-deferred
- Distributions used for educational expenses are exempt from federal income tax
- Income and investment restrictions are non-existent
The Securities & Exchange Commission notes that two 529 account types are available: a prepaid tuition plan and a college savings plan. According to FinAid.org, all 50 states (and the District of Columbia) make college savings plans available to legal residents. Prepaid plans are available in 16 states.
The Prepaid Tuition Plan
- Account holders can buy credit units for future use in paying tuition and administrative fees (along with room and board, in some cases)
- Students pay tuition at a fixed rate determined at the time of the initial investment, meaning rates will be protected from future inflation
- The state guarantees the plan to help mitigate risk
The College Savings Plan
- There is no age or grade limit, nor is there a state residency requirement, which allows students and parents to consider a greater number of plans
- Generally no enrollment period
- Tuition prices aren’t locked in and the state assumes no responsibility for account funds if the market underperforms, making these plans slightly riskier
Access to a 529 savings plan may affect the beneficiary’s eligibility for need-based financial aid. On the Free Application for Federal Student Aid, both 529 options are treated as ‘parental assets’ and included in the household’s ‘expected family contribution’ for college expenses.
Where and how you enroll in a prepaid tuition or college savings plan will depend on your state of residence. Please visit FinAid.org or Morningstar to view state-specific lists of all available 529 plans.
Coverdell Education Savings Account (ESA)
A Coverdell Education Savings Account (ESA) is another vehicle designed specifically for college savings. Single parents who earn an adjusted gross income of $110,000 or less per year ― or two parents jointly filing who earn $220,000 or less ― may obtain a Coverdell ESA for their child. In any given year, the contributions toward this account may not exceed $2,000; if multiple accounts have been opened for the same beneficiary, then combined contributions must not exceed this amount. Additionally, beneficiaries must be younger than 18 (exceptions may be granted for disabled or special needs learners). Coverdell ESA plans may be used to fund private elementary or secondary educational expenses, as well as collegiate costs.
Unlike the 529, Coverdell ESA plans are not tax-deductible. However, the funds will stay interest-free until the beneficiary is allowed to access them.According to the IRS, funds from a Coverdell ESA can be used at “virtually all accredited public, nonprofit and proprietary (privately owned profit-making) postsecondary institutions.” If there are funds remaining in the account by the time the beneficiary turns 30, in most cases, these funds must then be distributed no more than 30 days later.
If the student is also the official account-holder and considered financially independent from their parents, then a Coverdell ESA may impact eligibility for federal financial aid. However, if the student is considered a financial dependent or the student’s parents are the registered account-holders, then the Coverdell ESA will not significantly affect eligibility for need-based federal aid.
To learn more about the Coverdell ESA, please review IRS Publication 970. You can enroll in this savings plan through different financial brokers. Major Coverdell ESA providers include TD Ameritrade, Scottrade, E-Trade, Schwab, TradeKing and Capital One 360 Sharebuilder.
Uniform Transfer to Minors Act (UTMA)
Families with a high level of disposable income, may want to consider investing in alternative vehicles that allow more flexibility in how the funds are used. Forbes contributor William Baldwin noted that UTMA custodial accounts are rarely the most cost-effective college savings plan; the exception to this rule is any family whose annual income is so high that their children will not be eligible for any need-based financial aid. Federal ‘kiddie tax’ rules require investment income to be declared on a parent or guardian’s tax form until the student either:
- Reaches the age of 24
- Files a joint-return with a spouse
- Or is able to cover more than half of his or her living expenses
The only tax break for the student is an exemption on the first $1,000 of unearned income; the next $1,000 will be taxed at a rate of 15%. There is no contribution limit for UTMA custodial accounts, but depositing more than $14,000 per beneficiary will exceed the current limit for gift tax exclusions (and additional taxes will be applied).
It should be noted that funds from custodial accounts (unlike 529 plans or Coverdell ESAs) do not need to be applied toward qualified educational expenses; if the beneficiary does not attend college, then they can use the funds as they wish. However, if the beneficiary is financially independent and they choose to enroll in a higher-learning institution, the custodial account will significantly impact their eligibility for need-based federal financial aid. Custodial accounts for financially dependent students and UTMA 529 plans are considered assets of the parents, and will not have as much impact on financial aid eligibility.
The following four financial accounts may be used to cover a range of expenses. Often times people think they can rely on these sources of funding to pay for their children’s education, and that education-specific accounts are unnecessary. However, you’ll see that this strategy is generally not advisable.
Paying for college with monies from a mutual fund is generally not as cost-effective as 529 savings plans, because 529 plans are tax-sheltered. Capital gain distributions from a mutual fund, on the other hand, are currently taxed at a rate of 10-20% (depending on the investor’s income bracket). Additionally, the appreciation of any liquidated mutual funds used to pay for college will also be taxed. Mutual funds are only more cost-effective when expenses from a 529 plan are abnormally high and the account-holder is listed in the lowest income bracket.
A 401(k) is maintained by employers who deduct a predetermined amount of money from the worker’s paycheck and contribute it to the account. In some cases, the employer will contribute an equal amount of money from company accounts (a process known as ‘matching’). Generally, 401k funds cannot be withdrawn without penalty until the account holder is 59 1/2. This severely limits their effectiveness as a savings vehicle. Paying for your child’s higher education using IRA monies will also impact the student’s eligibility to receive need-based financial aid. These funds should be reserved for retirement expenses as they are intended.
Here at Online Colleges, affordability is a key concern for us. As we develop rankings to evaluate colleges and their programs, we measure academic quality but never forget how important affordability is to students.
If you are about to attend college and haven’t chosen a major, we’d like to direct you to an affordable and academically robust school. Below, we’ve linked to our rankings of the top programs around the country in a variety of disciplines. As you search for the right college and major, be sure to take a look at our lists.
You can learn more about college savings plans by visiting the following resources:
- 529.com: This website dedicated to the 529 savings plan features specific information for parents, grandparents, distant relatives, family friends, employers and financial advisors.
- U.S. News & World Report: Paying for College: In addition to a section devoted to 529 plans and other college savings options, this page features information about financial aid, net tuition cost calculations, paying for online education and other related topics.