While you can certainly sock away money for college in a piggy bank or savings account, there are better ways to save.
The best option for most people is a 529 plan. These accounts, which earn their name from the section of the tax code that created them, are kind of like IRAs for college. While contributions can’t be deducted from your federal taxes as IRA savings can, you may be able to deduct the amount you save from your state taxes. Plus, your earnings grow tax-free, as with an IRA. And if you spend the profits on approved college costs — including tuition, books, room, and board — you can withdraw the money tax-free as well.
There are a few caveats, of course. For one, if you withdraw the money for non-educational purposes, you’ll pay taxes on earnings plus a penalty. Second, your child’s eligibility for need-based aid can be reduced each year by up to 5.64% of any non-retirement savings including 529 balances, though typically the impact on aid is smaller than that.
There are two types of 529s:
Self-directed college savings plans allow you to invest money that can be applied to costs at any accredited college. You can choose from a limited set of investment options, which typically include pre-made portfolios based on the child’s age. These start off very stock heavy and then shift toward bonds, which tend to be safer, as your child’s college enrollment date nears. Although most college savings plans are sponsored by states, you can invest in any state’s 529, even if you don’t live there or have a child planning to attend college there. See “What’s the best 529 plan for me?” for help determining which state’s plan to choose.
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Prepaid tuition plans are the other type of 529. These allow you to pay now for future tuition credits at an in-state school or a certain selection of private colleges, rather than investing the money. Prepaid plans are best for parents who have a fairly good idea of where their child will go to school and are willing to trade investment flexibility for the security of knowing exactly how much tuition they’ve paid for.
There are some drawbacks: For one thing, if you later withdraw the money for non-college uses, you may only get back the amount you contributed, with no growth. Also, some prepaid plans, such as Florida’s, charge parents a very high premium to lock in tuition costs. And many prepaid plans are facing financial difficulties because tuition has been rising faster than investment returns. As a result, 10 states have closed at least one prepaid plan to new investors as of 2014. But there are still 12 open plans, three of which will accept contributions from parents in any state.
Need the flexibility with your college savings? If you want to be able to have the option to use the money you save for retirement instead, you might consider a Roth IRA. A quirk in federal law allows you to withdraw contributions to this retirement account penalty-free for college expenses. Earnings are subject to income tax, however. And anyone counting on need-based aid to help pay for college should be careful: Withdrawals count as untaxed income on next year’s aid application. Also, your savings potential is relatively limited in that you can only put away up to $5,000 per year ($6,500 if you’re 50 or older), and only if you meet certain income restrictions.
Think you might want to use the money for K-through-12 school tuition? Married couples earning less than $220,000 a year can save up to $2,000 per contributor per child through a Coverdell Educational Savings Account. Withdrawals from Coverdells can be used-tax free for educational expenses for any grade from kindergarten through college.
Perhaps the most flexible option would be U.S. savings bonds: Couples earning less than $142,050 in 2013 can cash in Series EE or I federal savings bonds tax-free if the proceeds are used for educational purposes. You can use the money for anything else with no penalty, and your money is ultra secure. But the downside is a biggie: Savings bonds offer extremely low interest rates that are unlikely to keep up with tuition inflation.