7 Best Ways for Parents to Save for College
Plenty of people will tell you about the importance of college. They’ll tell you about how college graduates earn more during their lifetimes. They’ll tell you about how the value of college extends far beyond the academic experience. What they may not tell you is how you’re supposed to pay for it.
Of course, there are all kinds of financial aid available like grants and scholarships, but the most surefire and effective way to find the money for college is to save it yourself. We’re not talking about stuffing money in a shoebox and keeping it under the bed. We’re talking about finding the best way to save for college! Here are seven different ways families can invest and save money for college.
1. An Old-Fashioned Savings Account
Here’s a classic way to save for college: the good old savings account. You’re probably already more than familiar with the classic savings account and how it works. It’s a separate account you open through your bank or credit union and you save money whenever and wherever you can.
Savings accounts can be a great way to store a rainy-day fund because they are accessible, easy, low-risk, and they are insured. Just like that sticker you see at the bank drive-thru; your savings account is insured by the FDIC up to $250,000. That means that if your bank disappeared tomorrow, your money would still be safe.
However, while they’re safe and low-risk, your savings account isn’t going to get you much of a return on your investment. At most banks, you’ll be lucky if your interest rate is as high as two percent. Of course, you can also take comfort in the fact that you’re never going to lose money from your savings account. It’s a safe way to save, it just might not be the most effective.
2. Investing in Mutual Funds
Investing in mutual funds is more than a great way to save for college, it’s a great way to save and invest money in general. You probably hear about mutual funds a lot, but you may wonder exactly what a mutual fund is.
A mutual fund is an investment that takes money from lots of different investors (like you) and then invests that money in a larger group of investments (also known as securities). This group of investments may include different stocks and bonds chosen to provide a return on your investment.
Mutual funds are simple, diverse, and relatively affordable. Even so, you’ll likely have to put down at least $500 to get in on one. Mutual funds can be a great gateway to investing for people and, thanks to their diversity, are generally lower risk than putting money in a single stock. However, mutual fund distributions could mean you’re paying capital gains taxes on your investment each year, and when you sell the funds to pay for college, you’ll pay taxes again.
3. Starting a Roth IRA
A Roth IRA is another investment vehicle that can be just as valuable in saving for retirement as it is in saving for college. If your company doesn’t offer a 401k Plan for you to save for retirement, there’s a good chance that you have a Roth IRA. If not, you should seriously consider one. Saving for retirement is important! Saving for college is also important, which is why many people use a Roth IRA to save for both.
An IRA (or individual retirement account) is a tax-advantaged investment vehicle to help people save for retirement, among other things. The Roth IRA differs from a traditional IRA in one major way. Money in a Roth IRA grows tax-free, and then when you withdraw that money later, there’s no additional tax on your withdrawal.
By contrast, a traditional IRA lets you take a tax deduction on the money you invested that year, but when you withdraw that money later, it gets taxed as income. This is what makes a Roth IRA so great for long-term savings. If you plan on being in a higher tax bracket down the line when you withdraw that money, you can save big by not needing to pay taxes on it later.
When you withdraw money from an IRA, there’s no tax taken out as long as it’s been five years since you first contributed. What’s more, you can use a Roth IRA to pay for anything. The downside is that the yearly contribution limit is pretty low. You can only contribute up to $6,000 to a Roth IRA per year, which can help; but might not cover the complete cost of college.
4. Opening a 529 Account
529 plans are named after Section 529 of the IRS code that authorizes qualified tuition programs with particular advantages to help you save. A 529 plan is one of the most effective ways for people to save for college, which makes sense because that’s what it was designed for.
Money that is invested in a 529 plan grows tax-free until you decide to withdraw it for school. As long as your money is withdrawn for a Qualified Education Expense (which includes K–12 tuition in most states, including North Carolina), there are no additional taxes taken out of your withdrawal. The ability to specifically earmark funds for school can be advantageous for many families because it helps to keep things like your retirement savings and rainy-day fund entirely separate from your college fund.
One of the major advantages of a 529 plan is how accessible a 529 plan is for the average person. These plans are designed to help everyone save for college. Because of that, the minimum contribution limits are incredibly low. In fact, it only takes a $25 minimum contribution to start and fund an NC 529 Plan!
Furthermore, the contribution limits on 529 plans are much higher than those seen for ESAs or even a Roth IRA. The contribution limit for a 529 plan is based on the “Maximum Projected Expenses” for school. For an NC 529 Plan, this number is calculated on approximately how much it would cost for four-years of undergraduate study and three years of graduate school at the most expensive schools in North Carolina. As of this writing, the contribution limit for an NC 529 Plan is $450,000. This way, even the loftiest dreams of college can be a reality for all students.
5. Think About an Education Savings Account
An education savings account (or Coverdell ESA) is another investment vehicle offered by the government to help families save for college. On the surface, it may seem similar to a 529 account, but there are some key differences between the two that are important to consider.
The biggest differences are the options available for your investments. Unlike 529 plans, ESAs are not run by the states and you can run your ESA directly through your personal broker if you’d like. This also allows for a large range of options for your investments themselves. You can invest in any stock you want. Of course, this can also make your investment riskier if you don’t know what you’re doing.
The other key difference between an ESA and a 529 is the contribution limit. Families are only allowed to contribute up to $2,000 per year, per beneficiary, to their ESA. While we agree that every little bit helps, being capped at $2,000 a year can greatly affect how much college your ESA can cover and how much compounded interest you can expect to receive. It might also get confusing having so many types of accounts that you are using to save for college.
6. Qualified United States Savings Bonds
People have been using U.S. Savings Bonds as a way of saving money for a long time. The first savings bond was offered in 1935 to encourage people to save money during the Great Depression. Today, U.S. Savings Bonds are a trusted, affordable, and reliable way for families to save for all sorts of things.
One advantage of a savings bond is that you cannot lose the money on your principal investment. If you purchased a savings bond for $100, you can count on it being worth at least $100 by the time you cash it out. While savings bonds can be a safe way to save money for college or give as a gift, it can also feel complicated to withdraw that money for college when the time comes. That’s why many people elect to roll their savings bonds into a 529 plan before college. This way, they can ensure that their savings bond won’t be taxed.
7. Consider a Custodial Account
One final way you can save for college is by setting up a custodial account for your child. This is an account set up through your bank or credit union that is specifically built in the interest of a minor. The custodial accounts best for college savings are set up under the UGMA (Uniform Gift to Minors Act) and the UTMA (Uniform Transfer to Minors Act). In these types of custodial accounts, the parent or guardian donates money to the account and also manages the account. You get to name your beneficiary and decide when your child gets to access the money.
Money that has been placed in a custodial account can be used for anything, as long as it’s being done for the beneficiary. This can remove having to worry about whether or not something qualifies as a Qualified Education Expense. It also means the beneficiary can spend it on whatever they want when the account becomes theirs, so you better be sure you can trust your kid to use the money for school.
The biggest drawback of a custodial account might be how it can affect financial aid. Custodial accounts are applied to the beneficiary, not the custodian. That means it will be counted as a student asset on the FAFSA. As a result, a custodial account could reduce a student’s financial aid package by up to 20 percent of the account value. Depending on the size of the account, that could be a lot of money you were counting on for school. If you already have a UGMA or UTMA, considering rolling it into a 529 Account, which is easy to do when you enroll.
Find Which Way to Save for College Works Best for You
As you can see, there are all kinds of ways that you can save for college, and they all have their benefits and drawbacks. The best way to save college is what works best for you. Do your research so you can make an informed decision and see which way to save works for you and your family. Regardless of how you save for college, what matters is that you do! When you’re ready, NC 529 can help you save for school and answer any questions you might have about the process.