Choosing the Right College Savings Account for Your Child

How to Choose the Right Kind of Account for Your College Fund

Mother and daughter in graduation gown hugging on campus, rear view
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Choosing the right college savings account for your child can seem overwhelming. There are several options, each with unique sets of complex rules. But making the right choice while your child is young—even a baby—can save you a lot of angst down the road when it comes time to apply for financial aid and search for scholarships. You can find the right type of college savings account for your child by answering a few questions.

What Is Your Risk Tolerance?

If safety of funds is your primary concern, then find out if your state offers a Section 529 prepaid tuition plan. These state plans let you buy tuition in today's dollars and get an equivalent amount of money for tuition in the future—sometimes guaranteed by the issuing state. It’s unlikely that these plans will outperform the stock market, but your money will likely be safe.

The federal government does not guarantee prepaid tuition plans, but some state governments do. However, some states do not guarantee them. To prevent losing some or all of your money, check to make sure your prepaid tuition payments are guaranteed.

If you're willing to take more risk in exchange for a possible higher rate of return, then you need to determine if your state offers a Section 529 investment tuition plan, also known as an Education Savings Plan. These plans provide you with options from reputable investment firms. If the market rises, your investment will increase accordingly, but it can also decrease if the market suffers a downturn.

Series EE and Series I bonds have historically earned 3% to 6%, which lags behind the Section 529 prepaid tuition plans. Using bond mutual funds in any of the other savings plans may offer an equal historical rate of return, but is also subject to volatility and potential losses.

Where Do You Live?

Many states offer substantial financial incentives for using their in-state Section 529 Savings Plan. Considering that some states essentially put cash back into your pocket for using their plan, it seems wise to take advantage. You might be eligible to receive a deduction or credit on your state income tax return, or your state might actually match your contributions to the plan, up to certain limits, if you are a resident.

Since many states offer at least one or two good long-term stock market options in their savings plans, it's probably a good move to take the "free money." Even if you don't have access to your favorite mutual fund, this initial boost can lift your returns over time.

Since most states' 529 plans primarily cover public colleges and universities, you might want to consider the Private College 529 Plan if you think your child might attend a private school.

Can You Save $2,000 Per Child Per Year?

If you can save more than $2,000 per year, a Section 529 Savings Plan might be your best choice. The only caps placed on contributions to Section 529 savings plans are "lifetime" totals for each child. Parents can contribute to lifetime maximums that range from the low $100,000s to over $300,000. Even better, these sums grow tax-deferred and may be potentially withdrawn tax-free. Best of all, Section 529 accounts allow the assets to remain under a parent or donor's control forever. They're even allowed to take the assets back for personal use.

If you cannot save $2,000 per year, on the other hand, then a Coverdell Education Savings Account (ESA) might be good for you. A Coverdell ESA offers freedom in selecting your investments, as well as much looser standards on how the money gets spent (including tuition for grades K-12). The case for a Coverdell gets even stronger if you have multiple children because you can transfer unused funds to another Coverdell account, or use the funds to set up a new one for other family members, including grandchildren.

What About UGMAs, UTMAs, Roth IRAs, and Trusts?

While these vehicles offer some unique planning opportunities, they will not serve most families as well as Section 529 plans or Coverdell ESAs.

UGMA and UTMA (Uniform Gift to Minors Act and Uniform Transfer to Minors Act) custodial accounts count almost four times as heavily against financial aid and require the assets to be handed over to a child no later than age 21. Buying individual bonds in a UGMA or UTMA might get you close to the return of prepaid tuition plan, but will be subject to taxation on any interest earned above a certain amount.

A Coverdell ESA or a Section 529 account offers virtually the same tax benefits as a Roth IRA, without wasting a valuable opportunity to save for your retirement.

Trusts may sound impressive but are extremely expensive to set up and run. Don't consider one unless you want to exceed the maximum allowable Section 529 Plan contribution limit.