According to our annual College Savings Survey, 68% of respondents have already started saving for college using a variety of different accounts. And 44% of those who aren’t saving say they haven’t started because they don’t have time to research their options. To help these families, we’ve listed six common ways you can start a college fund, and the biggest pros and cons of each:
1. Mutual Funds
Pros:
The funds you save in a mutual fund can be spent on anything – cars, airline tickets, computers, etc.
There’s no limit as to how much you can invest here are more than 10,000 mutual funds available, with a wide variety of investment options.
Cons:
Earnings in a mutual fund are subject to annual income taxes.
Any capital gains are taxed when shares are sold.
Mutual funds assets owned by a parent will reduce financial aid eligibility by up to 5.64% of the account value, and by 20% if owned by the student.
2. Custodial accounts under UGMA/UTMA
Pros:
Money saved in a custodial account can be spent on anything – cars, airline tickets, computers, etc, as long as the funds are used for the benefit of the minor.
There is no limit as to how much you can invest.
The value of the account is removed from donor’s gross estate.
Cons:
Earnings and gains are taxed to the minor and subject to the “kiddie tax” - unearned income over $2,100 for certain children through age 23 is taxed at the marginal rate applicable to trusts and estates (in 2018).
The student will gain rights to the account once he or she reached legal age, and can use they money at their own discretion.
Custodial accounts are counted as a student asset on the FAFSA, which means they can reduce a student’s aid package by 20% of the account value.
3. Qualified U.S. Savings Bonds
Pros:
U.S. savings bonds are federal tax-deferred and state tax-free.
Series EE and I bonds purchased after 1989 may be redeemed federally tax-free for qualifying higher education expenses.
Bond owners are investing in interest-earnings bonds backed by the full faith and credit of the U.S. government.
Cons:
The maximum investment allowed is $10,000 per year, per owner, per type of bond.
The interest exclusion phases out for incomes between $117,250 and $147,250 (in 2018) for married couples filing jointly or $78,150 and $93,150 for individuals.
If bond proceeds are not spent on tuition and fees, interest earned will be included in federal income and subject to tax.
4. Roth IRA
Pros:
Contributions can be withdrawn at any time for any reason.
The normal 10% early withdrawal penalty on earnings is waived when the funds are spent on qualified higher education expenses.
There is a broad range of investment options available.
The value of retirement accounts is not counted as an asset on the FAFSA.
Cons:
In 2018, the maximum investment allowed is $5,500 ($6,500 for taxpayers 50 and over).
Only married couples earning less than $189,000 (in 2018) or individuals earning less than $120,000 may contribute the maximum amount.
Married couples earning who earn $199,000 or more are ineligible to contribute ($135,000 for individuals).
Withdrawals from a Roth IRA to pay for college is counted as base-year income on the FAFSA.
5. Coverdell ESA
Pros:
Coverdell Education Savings Accounts (ESAs) you can take advantage of tax-free withdrawals to pay for qualified higher education expenses and also K-12 expenses.
There are a broad range of investment options available, including the ability to self-direct your investments.
The value of a Coverdell ESA account is counted as a parent asset on the FAFSA, no matter whether a parent or dependent student owns it.
Cons:
The maximum investment allowed is $2,000 per beneficiary per year, combined from all sources.
Contributions have to be made before the beneficiary turns 18, and the account can only be used until they turn 30.
Only married couples earning between $190,000 and $220,000 or individuals earning between $95,000 and $110,000 are able to contribute.
6. 529 plan
Pros:
Withdrawals spent on qualified higher education expenses and up to $10,000 per year in K-12 tuition avoid federal tax, and some states offer additional state tax benefits.
Depending on which plan you use, maximum investments can exceed $500,000 over the life of the account, and deposits up to $15,000 per year per individual will qualify for the annual gift tax exclusion.
There’s also an option to treat a contribution up to $75,000 in one year as if it were made over a five-year period to shelter a larger amount from taxes.
529 plans receive favorable financial aid treatment: accounts owned by dependent students are treated as parent assets and nothing has to be reported on the FAFSA when the funds are withdrawn to pay for college.
Cons:
Earnings are subject to income tax and a 10% penalty if the withdrawal is not spent on qualified education expenses.
Investment strategies available are limited to what’s offered by the program.
Withdrawals from accounts owned by someone other than the student or their parent have to be added back to the student’s income on the following year’s FAFSA and can reduce aid eligibility by as much as 50% of the amount of the distribution.
