Accounting for inflation, college tuition has increased over 200% for public schools and over 100% for private schools from 1988 to 2017. Throughout the U.S., college students and their families often have difficulty paying for school, especially since wages have not kept up with college tuition costs. For this reason, young parents should start researching the best ways to save for college as soon as possible.
This guide contains information about multiple college savings best practices, including savings accounts, Coverdell Education Savings Accounts (ESAs), 529 plans, and investment accounts. You will also learn how financial aid can help learners at any age earn a degree while reducing their out-of-pocket costs.
For Parents: Your College Saving Options
Around 65% of U.S. parents create college savings accounts for their children. However, traditional savings strategies cannot keep up with rising tuition. Parents who have saved for their children's college education typically find they can pay for only one semester at a private four-year college or university.
This section covers some modern college savings strategies that give parents a higher return on investment and allow children to incur less debt. Obviously, the sooner you start saving money, the more you can set aside for your children's future.
- High-Interest Savings Account
High-interest, or high-yield, savings accounts give parents a low-risk option to create a college savings account for their children. As the name indicates, these accounts pay considerably higher interest than traditional bank accounts. Unlike certificates of deposit (CDs), high-interest savings accounts allow depositors to withdraw money at any time, a safeguard for families needing immediate access to funds during a financial emergency. The banks that offer these accounts may charge fees or require minimum balances. For this reason, you should compare banks' policies for each account type or meet with a financial advisor to discuss your options.
- Coverdell Education Savings Account (ESA)
Coverdell ESAs offer increased flexibility when it comes to controlling your investment, but they are much more limited regarding the amount of money you can contribute. If you have significant funds to invest, a 529 college savings plan (detailed in a later section) or a combination of a 529 plan and an ESA is usually the recommended route.
Income and Contribution Restrictions:
- Single parents who earn an adjusted gross income of $110,000 or less per year -- or two parents filing jointly who earn $220,000 or less per year -- may obtain a Coverdell ESA for their child.
- In any given year, contributions may not exceed $2,000.
- Coverdell ESA plans are not tax-deductible.
- Distributions greater than the amount needed to cover necessary expenses for school may be taxed up to 10%.
Financial Aid Considerations:
- This plan may affect financial aid eligibility for students who are the official account holder and are considered financially independent.
- It should not affect eligibility for need-based aid when parents are the account holders and the student is a dependent.
To learn more about the Coverdell ESA, please review IRS Publication 970. You can enroll in this type of savings plan through different financial brokers. Major Coverdell ESA providers include TD Ameritrade, Scottrade, E-Trade, Schwab, TradeKing, and Capital One 360 Sharebuilder.
- Uniform Transfer to Minors Act (UTMA)
Minors cannot legally acquire stocks, bonds, mutual funds, annuities, life insurance policies, or other securities and monetary assets that require a signed contract. Parents or guardians cannot award these assets to their children or wards. However, donors may deposit assets into trust funds to be awarded to minors when they reach legal adulthood.
"UTMA account" is an umbrella term that applies to any custodial trust. This includes a UTMA 529 account, which is essentially a 529 savings plan supported through a custodial trust. UTMA custodial accounts are rarely the most cost-effective college savings plan options; the exception to this rule is any family whose annual income is so high that their children will not be eligible for need-based financial aid.
- The only tax break for the student is an exemption on the first $1,000 of unearned income; the next $1,000 will be taxed at a rate of 15%. There is no contribution limit for UTMA custodial accounts, but depositing more than $15,000 per beneficiary will exceed the current limit for gift tax exclusions (and additional taxes will be applied).
- Custodial accounts (unlike 529 plans or Coverdell ESAs) do not need to be applied toward qualified educational expenses; beneficiaries who choose not to attend college can use the funds as they wish.
- Custodial accounts will greatly impact students' eligibility for need-based federal financial aid if they are financially independent of their parents.
- Custodial accounts for financially dependent students and UTMA 529 plans are considered assets of the parents, so they stand to impact financial aid eligibility to a much lesser extent.
- Uniform Gift to Minors Act (UGMA)
Since 1956, parents have been able to save for college through the UGMA. In the simplest terms, the UGMA allows parents to make a financial gift to their children. The funds remain in a special account until the children become legal adults. Before children turn 18, someone (e.g., a parent or financial advisor) manages the account as a custodian. The custodian must apply fiduciary responsibility when making decisions for the account. The custodian cannot withdraw funds or take other actions that would cause the account to lose significant value.
Unlike UTMA accounts, UGMA accounts belong to the child. Finally, although all states allow UGMAs, South Carolina and Vermont do not allow residents to set up UTMAs.
As of 2019, a child can receive up to $15,000 from each parent. Although the federal government taxes the initial deposit at the standard rate, it applies a special, lower tax rate to all earnings until the recipient is 24 years old. This way, the account can continue to grow throughout the child's college education.
- As with other college savings accounts for children, college students can spend UGMA funds on much more than tuition.
- Many parents set up a UGMA account to ensure that their children receive financial assistance if one or both parents become deceased. A UGMA account's legal simplicity makes it an attractive option compared to a trust.
- UGMA accounts allow only financial assets. For this reason, parents with tangible wealth (e.g., jewels or artwork) should consider a UTMA account for saving for college.
- Investment Accounts
Some parents may be tempted to use their retirement accounts as a means to pay for their children's education; however, this is rarely a good idea. We'll take a look at why some of the most common accounts shouldn't be used for college savings.
To use 401(k) funds to pay for an education, account holders must declare a hardship withdrawal, demonstrating an immediate need for disbursement after exhausting other resources. Account holders younger than 59 1/2 must pay a withdrawal penalty and will be subject to having the funds taxed at a higher rate. In addition, these funds can affect a student's eligibility for financial aid.
Using IRA funds to pay for your child's education results in extra tax penalties and a reduction of need-based financial aid, making this an inefficient means to fund an education.
Paying for college with monies from a mutual fund is not as cost-effective as a 529 savings plan because 529 plans are tax-sheltered. Capital gain distributions from a mutual fund, on the other hand, are currently taxed at a rate of 10-20% (depending on the investor's income bracket). Additionally, the appreciation of any liquidated mutual funds used to pay for college will also be taxed.
- 529 College Savings Plan
Also known as a “qualified tuition plan,” the 529 plan rewards those who save for college by providing them with tax advantages. The Securities and Exchange Commission (SEC) notes that two 529 account types are available: a prepaid tuition plan and a college savings plan. According to FinAid.org, all 50 states (as well as the District of Columbia) make college savings plans available to legal residents. Prepaid plans are available in 16 states.
Prepaid Tuition Plan
- This plan enables the account holder to buy credit units at higher-learning institutions that will be used in the future to pay tuition and administrative fees (as well as room/board, in some cases).
- Tuition costs are essentially locked; enrolled students pay tuition at a fixed rate determined at the time of the initial investment, meaning rates won't be adjusted at a later rate -- protecting against future inflation.
- Plans often are guaranteed by the state, which mitigates market risk somewhat.
- Most plans impose an age or grade limit on beneficiaries (such as 18 years).
- Individuals may set up a prepaid tuition plan only during a standard enrollment period.
The College Savings Plan
- College savings plans allow account holders to set aside funds for the plan beneficiary.
- Money saved will eventually be used to finance tuition, room and board, and other college expenses.
- Plans do not impose an age or grade limit, nor do they require state residency, which allows students and parents more flexibility.
- In general, the enrollment period is not limited.
- This plan is slightly riskier than a prepaid plan, since tuition prices aren't locked in and the state assumes no responsibility for the account if the market underperforms.
- Prepaid plans typically involve a lump sum, with a schedule of payments based on the age of the beneficiary and the number of years they are expected to attend school.
- College savings plans have a set maximum accrual amount.
- Both accounts are tax-free, and some states even provide tax benefits or other incentives.
- Funds not withdrawn and not used for higher education-related expenses may be taxed up to 10%.
Financial Aid Considerations:
Expert Interview: Stuart Ritter: Vice President, T. Rowe Price Investment Services
After earning a master's in political science from American University in 1993, Stuart Ritter embarked on a career promoting personal finance. His professional experience includes working as a senior financial planner at T. Rowe Price Investment Management since 2009. He also teaches college courses and works with individual clients. The following expert interview with Mr. Ritter includes valuable information on how parents should save for college in the 21st century.
- What's the biggest mistake you see families make when saving for college?
The biggest mistake parents make is not saving at all. Some parents forgo contributing to a 529 plan, assuming their child will qualify for aid or scholarships, but that outcome is not guaranteed. In addition, individuals mistakenly assume that savings will hurt their chance of qualifying for federal loans, when in fact federal financial aid is primarily based on your income. The amount you have saved has very little impact on that formula.
If your child does earn a full scholarship to college, you can change the account beneficiary to another family member -- or even yourself.
- Are there any upcoming changes that will affect how parents save for college?
We don't anticipate any major upcoming changes that will affect how parents should be saving for their child's college education.
- Do you recommend different strategies for families with more than two children?
Yes. We recommend a different 529 account for each child. The money needs to be invested differently since each child has a different time horizon.
- Do you typically advise parents to use a Coverdell Education Savings Account, 529, both, or neither?
T. Rowe Price recommends that parents use a 529 plan to save for their child's college education, as there are some distinct advantages:
- You control the account and can change the beneficiary at any time, subject to IRS regulations.
- Any earnings are tax-deferred.
- Distributions are exempt from federal income tax if used for qualified education expenses.
- There are no income restrictions or limits to investing in a 529 plan.
A 529 savings account is a great vehicle to prepare for the rising costs of college and reduce your need to borrow money when your kids head off to school.
- When is the best time to start saving for college? What's the latest age parents can consider starting a savings account for their child?
It's never too early or too late for parents to start saving for their children's higher education. A 529 plan can be opened as soon as, or even before, a child is born. The earlier you start setting money aside in a 529 account, the longer that investment will have to benefit from tax-deferred growth potential. If you can't afford to save enough to pay the whole bill, consider aiming to make a sizable “down payment” by saving for about half the costs.
- What's the monthly contribution a family should consider to effectively save for their child?
To help families create a plan and start saving an appropriate amount for college, T. Rowe Price ran an analysis and found that a family would have to save over $400 a month from birth through the four years of college in order to cover the total costs at the average four-year, in-state public university. If this isn't feasible, consider starting with half the amount and aim to increase it. If you can work a couple hundred dollars into your monthly budget to help offset the future expense of college, you will be so much better off by the time your child is ready to enroll.
- What should you do if you haven't saved for your child's education?
Do the same thing you would do for any purchase you hadn't saved for. Be very judicious about how much debt you take on. There are many colleges to choose from, at many different price points. Give careful consideration to the value you're getting for your money, given your financial situation.
- What if you save for your child's college education and they decide not to attend?
If the beneficiary listed on the account doesn't go to college or, for any reason, doesn't use all the money, you have options:
- You can change the beneficiary on the account to another sibling, a cousin, a grandchild, or even yourself -- and use the money for the account beneficiary without any penalty.
- For 529 college savings plans, the money can also be used for higher education expenses other than undergraduate tuition, such as graduate school tuition, room and board, books, and supplies.
- If you do need to withdraw funds for anything other than a qualified educational expense, you'll need to pay income taxes on those earnings, as well as a 10% penalty on the earnings.
- Is there any final advice you would like to give that wasn't covered here?
Remember that saving for college doesn't have to fall on your shoulders alone. Aiming to save a down payment, asking friends and family to make gift contributions to your 529 plan, having your child pay for a portion, as well as exploring alternative sources of college funding (such as scholarships, grants, and other financial aid), can all add up and make paying for college a reality.
For Students: Your College Saving Options
Shortly after or even before their children are born, responsible parents start saving money for their kids' college education. However, when those children reach a certain age, they can contribute to their college funds, too. Starting in high school, students can research scholarships, find a part-time job, and explore other unique ways to start saving for college. Much of the information in this section also applies to older learners entering college for the first time or returning to complete a degree.
The links in this section are valuable resources that can help you earn a degree without going into debt.
If you cannot save enough money to pay for college, scholarships are your best bet for earning a degree without going into debt. Approximately 66% of students use scholarships to help finance a college degree. But what about the other 34%? Some students apply to scholarships unsuccessfully. However, many do not know where to look for information. Scholarship databases and other scholarship search tools can help you discover opportunities.
On these sites, you can enter your GPA, ethnic background, extracurricular activities, and other factors to search for scholarships for which you might qualify. Finally, as some scholarships do not consider financial need, nearly all college students can discover a relevant scholarship opportunity.
Many high school students take part-time jobs to save for college tuition and other expenses, such as textbooks. When they start saving early, their funds can grow significantly in a high-interest account. Learning how to balance a job and high school classes can also teach students how to handle multiple responsibilities, a skill that catches the eye of college admissions counselors.
That said, there are both short- and long-term risks for learners who keep a part-time job in high school. Students without financial literacy skills may spend more of each paycheck than they save. Also, poor time-management skills can translate to lower grades, stress, and burnout. To avoid these risks, students should carefully consider the job's responsibilities and the hours they can work without hindering their studies. Your education comes first, not your paycheck.
How to Save Your Money
Although degree-seekers cannot open a 529 college fund for themselves, they still have many options when it comes to saving for college. The first step involves determining how much money you need. After that, start your research by exploring the best high-interest savings accounts.
Due to historically low interest and inflation rates, CDs alone cannot adequately help you save for college. Also, the best CDs require depositors to keep money in the account for at least one year or face a financial penalty.
Besides researching high-interest savings accounts, determine if your bank offers special college savings accounts for individuals. Finally, many apps help people save for college, and credit cards often attract customers by boasting savings accounts with interest rates exceeding those of CDs.
This website features a database of information about all the college savings plans discussed in this article, as well as up-to-date news coverage of legislative developments, economic trends, and other factors that impact financial planning.
In addition to comprehensive information about different savings plan options, this site offers blog posts, lists, infographics, and interactive maps.
In addition to a section devoted to 529 plans and other college savings options, this page features information about financial aid, net tuition cost calculations, and paying for online education.