In short, contributing to a dedicated college savings account makes the most financial sense when:
- Your other financial priorities are on track,
- You can contribute a significant amount of money, AND
- You can contribute it early in your child’s life
So if you’d like to start saving for college, how do you know which type of account to use?
Here’s a detailed breakdown of the four major types of college savings accounts so that you can figure out which one is right for your specific goals.
Option #1: 529 Plan
The 529 plan is the most well-known college savings account, and for good reason. There are a lot of potential benefits and just about anyone can use them, making them very powerful in the right situations.
Let’s dive into the pros and cons.
Pros of the 529 plan
- Tax deferral – Money within a 529 plan is invested tax-free while inside the account, allowing it to grow faster than it would within a taxable account.
- Tax-free withdrawals – The money can be withdrawn tax-free for qualified higher education expenses (i.e. undergraduate programs and beyond).
- Potential state income tax deduction – Some states allow you to deduct your contributions for state income tax purposes (you cannot deduct them on your federal income tax return). Click here to see if your state allows a deduction.
- High contribution limits – There are no income limits with 529 plans, meaning anyone can contribute no matter how much they make. A married couple can also typically contribute up to $28,000 per year, per child without any tax consequences (and up to $140,000 in certain situations).
- Easy to start – Each state runs its own 529 plan, and most states make it pretty easy to get started. (FYI, you don’t have to use your state’s plan. It’s worth shopping around, especially if you aren’t offered a state income tax deduction for contributions.)
- Flexibility – You can change the beneficiary at any time. If the child you originally opened the account for doesn’t need the money, you can use it for another child, yourself, your spouse, a niece or nephew, or grandchild.
- Easy for others to contribute – Most 529 plans make it easy for friends and family to contribute directly if they’d like. It’s also pretty common for grandparents to open their own 529 accounts for their grandchildren.
Cons of the 529 plan
- Limited to higher education – The money can only be used tax-free for qualified higher education expenses. This obviously limits your ability to adapt if you don’t need the money for that purpose.
- Taxes and penalties – If you withdraw the money for any other purpose, your earnings will be taxed as ordinary income and subject to a 10% penalty. There are some exceptions to this rule, such as when your child receives a scholarship.
Option #2: Coverdell ESA
The Coverdell ESA isn’t quite as well-known as the 529 plan, but it’s a great option, especially for people who can’t contribute quite as much and/or want a little more flexibility.
Pros of the Coverdell ESA
- Tax benefits – Just like a 529 plan, money within a Coverdell ESA is invested tax-free while inside the account AND can be withdrawn tax-free for qualified education expenses.
- Can be used for K-12 expenses – The big advantage of the Coverdell ESA over the 529 plan is that the money can be used tax-free for K-12 expenses in addition to higher education expenses. This includes things like tutoring, books, and private school.
- Flexibility – Just like with a 529 plan, you can change the beneficiary at any time and use the money for a different family member.
Cons of the Coverdell ESA
- Lower contribution limit – The maximum annual contribution to a Coverdell ESA is $2,000 per child. And married couples will see that allowed contribution reduced once their modified adjusted gross income exceeds $190,000, and eliminated completely at $220,000.
- No state income tax deduction – You will not receive any income tax deduction for contributing to a Coverdell ESA.
- Taxes and penalties – Like a 529 plan, your earnings are subject to taxes and a 10% penalty if not used for qualified education expenses.
- Harder to start – Coverdell ESAs aren’t as standardized as 529 plans, which can make them a little more difficult to set up. Here’s a list of Coverdell ESA providers.
- Tax deferral less valuable – If your plan is to use the money for K-12 expenses, it’s important to recognize that the tax benefits are less valuable over shorter time periods. The longer the money is saved, the bigger the benefits of tax deferral.
Option #3: Roth IRA
Yes, the Roth IRA is actually a retirement account, not a college savings account. But it has some unique features that can make it a smart place to put your college savings if you know what you’re doing.
Pros of a Roth IRA
- Tax deferral – Your money grows tax-free while inside a Roth IRA.
- Contributions are accessible – You can withdraw up to the amount you’ve contributed at any time and for any reason, without being taxed or penalized.
- No penalty for college expenses – Typically, the earnings you withdraw from a Roth IRA prior to age 59.5 are subject to a 10% penalty, but the penalty is waived when the money is used for qualified higher education expenses.
- Flexibility – If you don’t need or want to use the money for college, you can simply keep it in the Roth IRA, let it keep growing, and withdraw it tax-free in retirement.
- Financial aid – Money inside a Roth IRA is not counted against financial aid eligibility.
- Investment options – In contrast to a 529 plan, Roth IRAs offer pretty much unlimited investment options.
Cons of a Roth IRA
- Potentially sacrificing retirement – In general, it’s best to make sure that you’re 100% on track for retirement before saving for college. Using your Roth IRA for college savings may be sacrificing your personal financial future.
- Confusion – One of the benefits of a Roth IRA is that it can be used for either college or retirement. But it’s important to remember that it can’t be used for BOTH, so you shouldn’t count it towards both in your planning.
- Financial aid – Withdrawals from a Roth IRA are counted as income in the NEXT year’s financial aid calculations, even if the withdrawals aren’t taxed as income. And since income is weighed much more heavily than savings, that can be a big detriment.
- No state income tax deduction – Unlike some 529 plans, there is no state income tax deduction for contributions.
- Earnings are taxed – Any amount you withdraw over what you have contributed will be taxed as ordinary income.
- Smaller contribution limits – Your contributions are capped at $5,500 per year, and in some cases may be even more limited.
Option #4: Regular Investment Account
Regular investment accounts aren’t dedicated college savings accounts and they don’t offer any special tax breaks, but they do have some flexibility that can make them a good option.
Pros of a regular investment account
- Investment options – 529 plans are typically offer limited investment options, and with Coverdell ESAs you’re limited by the providers that offer them. But you can open a regular investment account with any investment company you’d like, which allows you to choose investments that align with your personal investment plan.
- 100% flexibility – You can use the money for any purpose at any time. No matter what you or your children decide to do with your life, this money is available to help you do it.
Cons of a regular investment account
- No tax benefits – While there are plenty of ways to invest tax-efficiently within a regular investment account, you don’t get the tax deferral and tax-free withdrawals that a dedicated college savings account offers.
- Account minimums – Some mutual funds and investment companies have account minimums that can make it difficult for someone who is just getting started.
Two other options
Here are two other options that you might consider, but that in most cases can’t match the benefits of the four options above.
UGMA and UTMA accounts are not something I generally recommend. There are no tax benefits for using them and you lose a lot of control over the money.
Savings accounts can be an easy way to get started, and they can be useful when you’ll need the money soon. But they are not a great long-term option simply because there are no tax benefits and you can find better returns elsewhere.
There’s no right answer here, but here’s a quick summary of when to consider each type of college savings account.
529 plans are generally best for people who are sure they want to save the money specifically for higher education, and especially for people can contribute a lot of money.
Coverdell ESAs are generally best for people who want the money available for K-12 expenses as well, and for people who don’t plan on making significant contributions.
Roth IRAs are generally best for people who are not 100% on track for retirement yet and want some flexibility to be able to use the money for either purpose.
Regular investment accounts are generally best for people who want the money available for any purpose at any time, whether it’s to invest in their children, themselves, or anything else.