Guide to College Savings Accounts: 529 Plans and More
September 30, 2016
With college costs rising every year, parents often worry whether they will have enough stored in savings accounts to pay for their children's education. Before taking out loans, determine your options for college savings plans, including a 529 plan in your state. Through the right college savings accounts, families could walk away with less student loan debt and a better financial footing after graduation.
The high cost of higher education
According to Fidelity Investments, parents plan to cover 70 percent of the cost of their children's higher education. However, based on their current savings, they are on track to only put away 29 percent of the expected price of a degree.
"We've got some definitely positive behaviors and optimism from families," says Keith Bernhardt, vice president of college planning for Fidelity Investments.
That's the good news from the firm's 10th Annual College Savings Indicator Study. However, there is still progress to be made. The number of parents saving for college is at an all-time high, but they may not be saving at a rate great enough to cover their future expenses.
Types of college savings accounts
Fortunately, for those who want to put more aside, there are several tax-favored accounts to use when you save for college. When it comes to how to save for college, parents will find the following are the most common options used today:
529 Plans: Two ways to pay for college
A 529 plan is often considered the best way to save for college. There are two types of plans available: those that allow people to essentially pre-pay tuition at today's rates and those that let people save money to be withdrawn tax-free for future qualifying education expenses. To sweeten the pot, some states allow residents to deduct their contributions to 529 plans.
"They've become very popular, especially because they are very flexible on who can put money in," says Bill Van Sant, senior vice president and managing director at Girard Partners headquartered in King of Prussia, Pennsylvania.
Some 529 college savings plans, such as those offered by Fidelity, allow parents to create personal webpages for their children that make it easy for grandparents and others to contribute to the fund.
Contribution limits for a 529 plan
Each person donating to a 529 plan can deposit up to $14,000 per year without incurring gift taxes or, in certain situations, make a lump sum deposit of up to $70,000.
Coverdell Education Savings Accounts
At one time, a Coverdell Education Savings Account was one of the most common ways to save for college. However, they seem to have fallen out of favor with the introduction of 529 plans that offer more flexibility and higher contribution limits.
"For my practice, we don't see much money [put into] these," Van Sant says.
Coverdell savings accounts vs. 529 plans
Contributions to Coverdell accounts, previously known as an education IRA, are capped at $2,000 per child per year.
What's more, money must be deposited before a child turns 18 and must be used by age 30, restrictions not found in 529 savings plans. However, these accounts do have a perk not found in 529s. Money from them can be used to pay for private school at the elementary and secondary levels in addition to college expenses.
Although a Roth individual retirement account (IRA) is intended for retirement funding, some parents are using it to pay for their children's college education. Money put into a Roth account is already taxed so the principal amount can be withdrawn prior to retirement without tax or penalty. Then, the gains can remain in the account to grow tax-free.
Why keep college and retirement savings separate
While it can be tempting to use a Roth IRA for the dual purposes of college and retirement savings, Van Sant cautions against comingling these funds.
"I would never lead with the IRA," he says. Instead of planning to use a Roth IRA, pulling money from it should be a last resort. "There's a big consequence. It's really dipping into one's retirement."
Checking or savings account
Checking and savings accounts don't come with any tax benefits and typically offer little, if any, interest nowadays. Still, they are a popular way to save for college.
"Actually, checking and savings is the No. 1 one way for saving [for college]," Bernhardt says.
While they may not be the best way to save for college when you consider the tax benefits of other options, Bernhardt adds there is nothing wrong with starting a college fund in a savings account.
"The simplest way is to have a dedicated account, he says.
To get the most out of their account, parents can research the best savings accounts or checking accounts with high interest rates. While the Federal Deposit Insurance Corporation reports the national rates for savings and interest checking accounts that contain less than $100,000 are close to zero, there are accounts available with bank rates at 1 percent or higher. These high yield savings accounts could mean a difference of thousands of dollars in interest earned once your child reaches college age.
Why find the best savings and checking rates for college savings
If you have an initial deposit of $10,000 in your savings account with an annual percentage yield (APY) of 1 percent when your child is born, you could earn about $1,971 in interest once your offspring turns 18. Compare this to the FDIC's average national rate for savings accounts (with less than $100,000) of just 0.06 percent APY with $108 in interest earned in 18 years.
This is a difference of about $1,863 over the course of your child's development and just a small amount compared to the staggering cost of college that will likely only grow.
If you have a specific savings goal in mind before your child heads off to college, use a compound interest calculator to see whether keeping your deposits in a regular or jumbo savings account is best for you.
How to select the right college savings plan
From a tax benefit standpoint, there is a lot to like about 529 plans. Money in the accounts grow tax-free and can be withdrawn tax-free for qualified education expenses.
"The only drawback would be if the child didn't ultimately go to school," Van Sant says.
In that case, money pulled from the account would be taxed and incur a 10 percent penalty. However, both can be avoided by changing the beneficiary to another child, grandchild or other relative.
The ability to change beneficiaries is an added benefit for high-worth families who want to minimize the size of an estate.
"[529 plans] are the only option I know of where the money leaves the estate, but you still control it and can take it back if you want," Bernhardt says.
However, if there's a good chance a child may forego college, it could be better to select a different college savings account. Bernhardt says the best advice is to not worry about picking the right savings account or finding the best 529 plans immediately.
"People sometimes feel a bit overwhelmed," he says. "Please don't let that stop you. You don't have to have a perfect plan - just get started."
More from MoneyRates.com: