It’s never too early to start saving for college and your child’s ongoing educational expenses. These days, there is such a variety, it’s probably not a case of either/or so much as which investment options to include to create a tax-saving portfolio that will meet your family’s needs.
The first step is to guesstimate how much it will cost to send your child to college for four to six years - the average time it takes to earn a degree. Calculate in-state and out of state tuition. Look at housing, food and transportation back and forth at least a couple of times per year, with books and incidentals added on. Get your target number. Scary, huh?
Now look at your child’s age. How much time do you have to save that amount? And will your child need any other educational expenses before they reach school, such as private education or extra tutoring?
Choosing the right savings methods
529 college savings and prepaid plans
529 plans are the most popular education-specific savings plan. They are similar to a 401k in terms of choosing investments. In some cases, they are a pre-paid tuition plan.
A 529 savings account allows you to invest in mutual funds with the same risk and return on investments of other stocks and shares. Pre-paid tuition plans allow you to effectively “lock in” tuition costs and avoid the impact of ever-increasing fees. Each state administers their own 529 account, so options vary. Many states offer tax breaks or credits to residents. Some even offer matching funds if you contribute. Your after-tax contributions will grow tax free.
Coverdell Education Savings Accounts (ESAs)
Education Savings Accounts (ESAs) are similar to a 529, and offer tax-free growth. But contributions are limited to $2,000 per year, and only until the beneficiary turns 18. There are also income limitations. The main advantage is that they offer more flexibility than 529 plans, with educational expenses from Kindergarten to grad school eligible.
Savings accounts can be opened and the money used for any purpose, but the return on investment will be small.
A Roth IRA uses after-tax contributions and will grow tax free. Withdrawals from a Roth are allowed penalty free for qualified education expenses, though they will generally be included as income in determining financial aid eligibility if they are in the name of the parent rather than another relative.
If your child gets a lot of scholarships, the money can keep growing for your retirement.
CDs and Savings Bonds
These both carry low interest rates these days that don’t keep up with inflation. But savings bond income is tax free if used for educational purposes.
Trust accounts are assets transferred to a child’s account and invested on their behalf until they reach the "age of trust termination" as defined by the state in which they live - usually between 18 and 21. They can then do what they want with the money, such as pay for college or backpack around the world. Once the money is theirs, it can affect their financial aid eligibility. There are some tax advantages for those making contributions to the trust.