Our Guide to Saving for College
A Guide To Help You Find the Best College Savings Option
After your child (or grandchild) is born, it’s natural to take a hard look at your finances and to see what steps you can take to provide a better life for your little one.
Starting a college fund early (just like retirement savings) is an important financial step that can help spare you and your child the significant financial burden that higher education can place on families in the form of student loan debt.
This page attempts to offer a detailed overview of some of the most popular strategies parents and grandparents use when saving for college. I’ll outline the benefits to each type of savings plan, its drawbacks, and I’ll also point out a few tips to help your dollar go farther.
Let’s get started.
Starting a college fund early (just like retirement savings) is an important financial step that can help spare you and your child the significant financial burden that higher education can place on families in the form of student loan debt.
This page attempts to offer a detailed overview of some of the most popular strategies parents and grandparents use when saving for college. I’ll outline the benefits to each type of savings plan, its drawbacks, and I’ll also point out a few tips to help your dollar go farther.
Let’s get started.
What is a 529 Plan?
One of the most popular methods of saving for college is a 529 plan. While it is not the only method of saving for college, many people consider it the best, as it comes with certain tax benefits.
A 529 plan is described by the SEC as “a tax-advantaged savings plan designed to encourage saving for future education costs.” Not only do 529 plans provide tax benefits (interest earned in your 529 is tax-free when used for qualified education costs), but setting up your 529 plan the right way can also offer need-based financial aid benefits when compared to many popular alternatives, which can reduce the amount of need-based financial aid a student qualifies for.
Nearly every state in the United States has one 529 plan available to residents, and some states have more than one. While you don’t need to use the 529 plan from the financial authority of your state, many people do because contributions can, in many cases, provide state income tax benefits. More than half of states currently offer some state income tax break for qualified 529 contributions.
A 529 plan is described by the SEC as “a tax-advantaged savings plan designed to encourage saving for future education costs.” Not only do 529 plans provide tax benefits (interest earned in your 529 is tax-free when used for qualified education costs), but setting up your 529 plan the right way can also offer need-based financial aid benefits when compared to many popular alternatives, which can reduce the amount of need-based financial aid a student qualifies for.
Nearly every state in the United States has one 529 plan available to residents, and some states have more than one. While you don’t need to use the 529 plan from the financial authority of your state, many people do because contributions can, in many cases, provide state income tax benefits. More than half of states currently offer some state income tax break for qualified 529 contributions.
The History of 529 Plans
In 1986 the Michigan Education Trust (MET) established the first 529 prepaid tuition plan and today’s 529 plans are named for Section 529 of the IRC (Internal Revenue Code) which authorized tax-free status for qualified tuition programs.
How do 529 Plans Work?
When you set up your 529 plan you are prompted to set it up with an account owner (usually a parent), and a beneficiary (the child who will attend college).
Grandparents and other family members can set up their own 529 plan (that they own) with a grandchild as a beneficiary as well, though there are financial aid implications to this, so I recommend that the 529 accounts are owned by the child’s parent … more on this later.
The money you deposit in your 529 is invested so that it grows as your child ages, and the interest your money earns will not be taxed providing it is used for education expenses when withdrawn from the account.
If you withdraw money from the account and do not use it for qualified education expenses the interest will be subject to income tax, and you will also have to pay a 10% penalty on the withdrawal.
The good news is that if you have more than one child, the funds are transferable to other family members. So if your oldest child goes to a state school and is awarded a generous scholarship, the excess funds in that child’s 529 can be transferred and used for another child or relative. If you’re fortunate and have money remaining after all of your kids have graduated, you can take some classes yourself, or just withdraw the money, pay the 10% penalty and any income tax incurred.
Grandparents and other family members can set up their own 529 plan (that they own) with a grandchild as a beneficiary as well, though there are financial aid implications to this, so I recommend that the 529 accounts are owned by the child’s parent … more on this later.
The money you deposit in your 529 is invested so that it grows as your child ages, and the interest your money earns will not be taxed providing it is used for education expenses when withdrawn from the account.
If you withdraw money from the account and do not use it for qualified education expenses the interest will be subject to income tax, and you will also have to pay a 10% penalty on the withdrawal.
The good news is that if you have more than one child, the funds are transferable to other family members. So if your oldest child goes to a state school and is awarded a generous scholarship, the excess funds in that child’s 529 can be transferred and used for another child or relative. If you’re fortunate and have money remaining after all of your kids have graduated, you can take some classes yourself, or just withdraw the money, pay the 10% penalty and any income tax incurred.
Are There Different Types of 529 Plans?
Yes. Generally there are two different types of college savings plan that are under the umbrella of a 529:
Each type of plan has distinct advantages.
The more popular 529 college savings plan is often chosen because parents do not know where their child will want to go to college. This plan gives the flexibility of applying the money saved and tax-free interest to higher education expenses at the school of the beneficiary’s choice.
Pre-paying is a good option if you feel confident that your child will want to go to the in-state public university because you don’t have to worry about the stock market and can simply counter the cost of inflation by paying tuition at today’s rate.
- 529 College Savings Plans tend to be more common, and these plans are used to save money to be put toward any qualifying education expenses like tuition, room and board, and textbooks.
- 529 Prepaid Plans are used to pre-pay part or all of the tuition costs of an in-state public college or university. The advantage to this is that you lock in the current tuition cost, so if tuition costs rise you won’t have to pay the inflated price of tuition for your child (and their tuition may be paid in full by the time they turn 18 and enroll).
Each type of plan has distinct advantages.
The more popular 529 college savings plan is often chosen because parents do not know where their child will want to go to college. This plan gives the flexibility of applying the money saved and tax-free interest to higher education expenses at the school of the beneficiary’s choice.
Pre-paying is a good option if you feel confident that your child will want to go to the in-state public university because you don’t have to worry about the stock market and can simply counter the cost of inflation by paying tuition at today’s rate.
What Exactly Are the Tax Benefits of 529 College Savings Plans?
The primary tax benefit of saving for college in a 529 plan is that the interest earned from the investment account will not be taxed if it is used for qualifying education expenses.
Secondary tax benefits depend upon where you live. Many states do offer state income tax breaks and incentives if you contribute to your state’s 529 plan.
Some states also offer matching grant money for annual contributions (for example, every child born in Maine is offered a $500 initial grant in a 529 account, and parents can earn up to $400 annually by contributing at least $600 each year).
If your state does not offer a tax incentive or grants, it is in your best interest to shop around and compare historic performance, relevant fees, etc. to choose the best 529 program for you. You will still enjoy the tax exemption of interest earned, so it’s smart to choose the program that will maximize this benefit by offering the best growth and lowest management fee combination. You can quickly find some of the best 529 college savings plans based on your search criteria here.
Secondary tax benefits depend upon where you live. Many states do offer state income tax breaks and incentives if you contribute to your state’s 529 plan.
Some states also offer matching grant money for annual contributions (for example, every child born in Maine is offered a $500 initial grant in a 529 account, and parents can earn up to $400 annually by contributing at least $600 each year).
If your state does not offer a tax incentive or grants, it is in your best interest to shop around and compare historic performance, relevant fees, etc. to choose the best 529 program for you. You will still enjoy the tax exemption of interest earned, so it’s smart to choose the program that will maximize this benefit by offering the best growth and lowest management fee combination. You can quickly find some of the best 529 college savings plans based on your search criteria here.
Using a Roth IRA to Save for College
If you are considering options beyond a 529 savings or pre-paid plan to save for college expenses, a Roth IRA may be worth considering.
Roth IRAs will typically enjoy similar growth to a 529 plan, but they offer you more flexibility about how the money can be used.
Typically you must pay a 10% penalty on early withdrawals from a Roth IRA, but that penalty is waived if you use the money for qualified higher education expenses (these expenses are the same as those for a 529). After 5 years and the age of 59 ½, your earnings can be withdrawn tax-free whether or not you use them for qualified education expenses.
There is a limitation on how much you can contribute to a Roth IRA annually (currently it is $5,500, or $6,500 if you are age 50 and over).
My one suggestion if you are planning to use a Roth IRA to save for college is that you should set it up with the student’s parent as owner. This will provide the best result for the student if they apply for need-based financial aid.
Roth IRAs will typically enjoy similar growth to a 529 plan, but they offer you more flexibility about how the money can be used.
Typically you must pay a 10% penalty on early withdrawals from a Roth IRA, but that penalty is waived if you use the money for qualified higher education expenses (these expenses are the same as those for a 529). After 5 years and the age of 59 ½, your earnings can be withdrawn tax-free whether or not you use them for qualified education expenses.
There is a limitation on how much you can contribute to a Roth IRA annually (currently it is $5,500, or $6,500 if you are age 50 and over).
My one suggestion if you are planning to use a Roth IRA to save for college is that you should set it up with the student’s parent as owner. This will provide the best result for the student if they apply for need-based financial aid.
How College Savings Can Impact Need-Based Financial Aid
Most people who save for college cannot cover the entire cost of higher education.
As a result, it is critically important that the way you save and who owns the savings accounts is set up to minimize the impact on the student’s need-based financial aid. The last thing you want is to save a lot of money for college but be refused financial aid to cover the cost you cannot pay for because your savings accounts were set up incorrectly.
Here is what you need to know to minimize the impact on how much need-based aid a student can qualify for:
As a result, it is critically important that the way you save and who owns the savings accounts is set up to minimize the impact on the student’s need-based financial aid. The last thing you want is to save a lot of money for college but be refused financial aid to cover the cost you cannot pay for because your savings accounts were set up incorrectly.
Here is what you need to know to minimize the impact on how much need-based aid a student can qualify for:
Assets Owned by the Parent
Assets in a 529 plan owned by the parent of a college student and with their child as the beneficiary will result in a reduction of financial aid by a maximum of 5.64% of the asset’s value.
So if you have a 529 account with $100,000 then the total amount of need-based financial aid your child can qualify for will be reduced by $5,640 as a result of that account.
So if you have a 529 account with $100,000 then the total amount of need-based financial aid your child can qualify for will be reduced by $5,640 as a result of that account.
Assets Owned by the Student
If the college student is financially independent and owns his or her own 529 plan, the rate of reduction of financial aid would be 20% of the college savings account’s value.
So if the student has a 529 account with $100,000 then the total amount of need-based financial aid he or she could qualify for would be reduced by $20,000 as a result of that account.
So if the student has a 529 account with $100,000 then the total amount of need-based financial aid he or she could qualify for would be reduced by $20,000 as a result of that account.
Assets Owned by Grandparents, Relatives or Friends
If a grandparent, friend, or relative opens a 529 account for a college student that is not their son or daughter, the impact of their contributions to qualifying education expenses is slightly more complicated. If a grandparent has a 529 account set up for their grandchild that money will not affect the student’s need-based financial aid until it is used, and once used the impact will be significant in subsequent years.
So if a grandparent has a 529 account with $100,000 for their grandchild, there would be no impact on need-based financial aid in the grandchild’s freshman year. But if the grandparent paid $40,000 from their 529 account toward the freshman year education expenses, then a 50% reduction in need-based financial aid would apply the following year (based on the money that was used). So during the grandchild’s sophomore year, the student would qualify for $20,000 less need-based financial aid.
So if a grandparent has a 529 account with $100,000 for their grandchild, there would be no impact on need-based financial aid in the grandchild’s freshman year. But if the grandparent paid $40,000 from their 529 account toward the freshman year education expenses, then a 50% reduction in need-based financial aid would apply the following year (based on the money that was used). So during the grandchild’s sophomore year, the student would qualify for $20,000 less need-based financial aid.
What About Financial Assets Outside of a 529 Account?
These same percentage reductions apply to any financial assets. If a student owns a Roth IRA account in the amount of $100,000, the amount of need-based financial aid they qualify for would be reduced by 20% of that asset’s value ($20,000).
If a grandparent paid $40,000 to cover college expenses for their grandchild’s freshman year, 50% of that ($20,000) would be the reduction in need-based aid they would qualify for the following year.
A parent’s financial assets generally have the least impact on need-based financial aid, and their assets will produce anywhere from a 2.6-5.6% reduction depending upon the type of financial asset.
If a grandparent paid $40,000 to cover college expenses for their grandchild’s freshman year, 50% of that ($20,000) would be the reduction in need-based aid they would qualify for the following year.
A parent’s financial assets generally have the least impact on need-based financial aid, and their assets will produce anywhere from a 2.6-5.6% reduction depending upon the type of financial asset.
So What's The Best Way to Set Up College Savings Accounts?
If you are a parent or relative, the best way to set up a college savings account for your loved one is typically to have the student’s parent own the account with the student named the beneficiary.
529 plans are great for this. Relatives who want to contribute to the student’s college savings can do so by mailing a check directly to the institution managing the account, and the impact on need-based financial aid for the student will be minimized.
If you are a relative who is not comfortable depositing money in an account owned by the student’s parents, you can set up a 529 account or similar savings account yourself, but I recommend having a discussion with the student’s parents when college age is near and perhaps you can plan to put the money you’ve saved toward the cost of the student’s final year of school … that way there will be no impact on need-based financial aid.
If you simply gift your grandchild a savings account to use in college, that asset will result in a reduction in their need-based financial aid so it’s important to think carefully about that and to discuss it with everyone involved in paying the student’s tuition, room and board, and other higher education expenses so that you fully understand the impact it could have on their financial aid.
529 plans are great for this. Relatives who want to contribute to the student’s college savings can do so by mailing a check directly to the institution managing the account, and the impact on need-based financial aid for the student will be minimized.
If you are a relative who is not comfortable depositing money in an account owned by the student’s parents, you can set up a 529 account or similar savings account yourself, but I recommend having a discussion with the student’s parents when college age is near and perhaps you can plan to put the money you’ve saved toward the cost of the student’s final year of school … that way there will be no impact on need-based financial aid.
If you simply gift your grandchild a savings account to use in college, that asset will result in a reduction in their need-based financial aid so it’s important to think carefully about that and to discuss it with everyone involved in paying the student’s tuition, room and board, and other higher education expenses so that you fully understand the impact it could have on their financial aid.
