Types of college funds for kids

Key points 

• College costs are skyrocketing, and that trend is expected to continue.
• The majority of families use parental income and savings to pay for college.
• Instead of using savings accounts, 529 plans, UGMA/UTMA accounts and Roth IRAs may provide higher returns and more benefits.
• Before opening an account, make sure you understand how it will affect the student’s eligibility for financial aid.

Have you looked at college costs lately? The price can be staggering, and the rates will likely continue to rise. According to Vanguard, in 10 years, a single year of college at an in-state public university could cost $36,960 — nearly 63% more than it costs today.

If you want to help your child earn their degree and avoid student loan debt, you may be considering starting a college fund on their behalf. It’s a common idea; according to a recent survey, 85% of families used parent income and savings to pay for college, contributing an average of $13,721 per year.

To help your money work harder, take advantage of special savings accounts and plans. By utilizing these college funds, you can help your money grow over time.

High-yield savings accounts

One of the easiest ways to stash money for college is to deposit your money in a high-yield savings account rather than your regular savings account.

Why is that a good idea? The national average APY on savings accounts was 0.06% as of January 2022. By contrast, high-yield savings accounts can offer APYs as high as 0.50%.

For those families that are unsure about their child’s future plans or are worried about other expenses popping up, a high-yield savings account offers the most flexibility. You can take out money without penalty no matter how you use it, and you can even decide to use the funds for another child, relative or friend.

However, high-yield savings accounts have a low rate of return, and there are no tax benefits. Also, when it comes to applying for financial aid, if the account is in your child’s name, it reduces the amount of need-based aid your child can get; if the account is in your name, though, it’s assessed the same way as a 529 plan (see below).

529 plans

A 529 is a tax-advantaged savings tool to save for a child’s future expenses. There are two types:

Prepaid tuition plan

A prepaid tuition plan allows you to purchase academic units or credits at current prices for future use by the designated beneficiary. This option may have residency restrictions, may be limited to just tuition and fees, and can only be used at its full value at participating universities. (You can roll over a prepaid plan into an education savings plan, but it may have less value.)

Education savings plan

An education savings plan is an investment account to save for qualified expenses including tuition and room and board. Investment portfolio options can include mutual funds, exchange-traded funds and savings products to potentially grow your contributions. Because your money is invested, there is some risk with 529 plans due to market changes.

According to Patricia Roberts, chief operating officer of Gift of College, 529 plans have several benefits.

“529 plans are not just for college,” she says. “Withdrawals from 529 plan accounts can be used to cover a wide range of education expenses at a wide range of accredited schools including two-year schools, four-year colleges and universities, trade schools and professional and graduate schools across the U.S. and the world. Covered expenses include tuition, fees, room and board, books, supplies and required equipment — including computers.”

You can also use up to $10,000 per year per beneficiary to pay for tuition at a public, private or religious primary or secondary school. 529 plans can also be used to repay up to a total of $10,000 per borrower in student loans borrowed by the beneficiary and the beneficiary’s siblings.

Your account withdrawals are tax-free when they’re used for qualifying education purposes. However, other withdrawals can incur both taxes and penalties. Although contributions to 529 plans aren’t tax deductible at the federal level, you may be able to deduct your contributions on your state income tax return.

529 plans are treated more favorably by financial aid formulas than money saved in the student’s name.

While there aren’t contribution limits for 529 plans, contributions over $16,000 per donor per beneficiary in 2022 will incur gift taxes. (Although you could take advantage of what’s known as superfunding, which treats a lump sum contribution of up to five times the annual gift tax exclusion as occurring over a five-year period.)

Coverdell education savings accounts

A Coverdell account is an investment account specifically designed to save for a child’s education. When you set up the account, you select a beneficiary and choose how to invest the money. The contributions can grow-tax free, and distributions from the account are tax-free when they’re used to pay for qualifying education expenses.

Unlike some other savings options, Coverdell distributions can be used to cover expenses for elementary or secondary school — including books, supplies and special-needs services.

Coverdell accounts have contribution limits; as of 2022, the maximum is $2,000 per beneficiary. However, high-earning households may be subject to stricter limits, and there are income restrictions to open an account.

You can contribute to a Coverdell account if your modified adjusted gross income (MAGI) is under $110,000 per year ($220,000 if you’re married and filing jointly). However, you’re limited to a reduced contribution amount if your income is between $95,000 and $110,000 ($190,000 and $220,000 for married couples filing jointly).

There are also age limits. Contributions must stop when the beneficiary reaches age 18, and the money must be used by the time the beneficiary reaches age 30.

UGMA/UTMA accounts

Coverdell accounts and 529 plans are the most popular options for college savings, but custodial trust accounts structured as a Uniform Gift to Minors Act (UGMA) or a Uniform Transfer to Minors Act (UTMA) are other possibilities.

With UGMA/UTMA accounts, a parent or relative can open the account and serve as the custodian. The custodian manages the account and makes investment decisions until the child reaches the age of majority in their state; in some states, the age is as low as 18, but in others, it can be as high as 21.

Once the beneficiary is granted the account, they can use the funds for whatever purpose they want—they’re not limited to using the money for education expenses. For example, they can decide to use the money toward a down payment on a home, or to purchase a car to commute to their new job.

Unlike other college savings options, the beneficiary cannot be changed on a UGMA/UTMA account. Also, contributions aren’t tax-deductible, and the earnings are subject to federal and potentially state taxes.

Another key consideration is the account is considered a student asset rather than a parental asset, which can impact their financial aid options.

Contributions above $16,000 per year ($32,000 for a married couple filing jointly) will incur a federal gift tax.

Roth IRAs

A Roth Individual Retirement Account (IRA) is a tool for saving for your retirement. But because of how Roth IRAs are structured, some people use them for college savings, too.

“These are tax-deferred investment vehicles that are typically used as an investment for retirement, but they may also be used to fund higher education expenses,” Roberts says. “Those investing for college may like the flexibility of being able to use these accounts for retirement if the money isn’t fully needed for higher education.”

Unlike other retirement plans, contributions to Roth IRAs are made with after-tax dollars. You can’t deduct your contributions, but your earnings and withdrawals aren’t taxed when they’re used in retirement as long as you’re 59½ and have had the account for at least five years.

Withdraws made before 59½ usually incur income taxes and a 10% early withdrawal penalty. But withdrawals used for education expenses are an exception. You won’t have to pay the 10% early withdrawal penalty, but you will have to pay income taxes on the earnings.

There is another unique feature that makes Roth IRAs attractive. You can withdraw your contributions from your Roth IRA at any time, at any age, tax-free without penalty.

However, a tax-free return of contributions is nevertheless reported as untaxed income on financial aid application forms and treated the same as taxable income in reducing eligibility for need-based financial aid.

• Contribution limits: You can contribute up to $6,000 per year to a Roth IRA ($7,000 if you’re 50 or older).
• Income restrictions: To contribute the full amount, your income as a single person must be under $129,000. If your income is between $129,000 and $144,000, you can contribute a reduced amount, but you can’t contribute at all if your income is over $144,000. The income phaseouts are $204,000 to $214,000 for married filing jointly.

If you are over the income limits for a Roth IRA, you may still be able to utilize one through a backdoor Roth IRA. If that’s an option you’re interested in, talk to a financial advisor.

Saving for college

As a parent planning for your child’s education, there are a variety of ways to save for college. The five options outlined above are the most popular, but they each have their own advantages and disadvantages.

“There is no one way to go,” says Roberts. “What’s important to remember is that regardless of the approach taken, every dollar saved is that much less that needs to be borrowed and repaid with interest when it comes time to pursue post-secondary education.”

Before opening an account, make sure you understand the pros and cons to maximize your savings.

“No matter what saving or investing options you pursue, what’s most important is to get started,” says Roberts. “Also, as a child nears post-secondary education, there will be many different educational options to pursue and the net costs will vary. You can avoid debt and regret by preparing in advance for educational costs and by choosing a school that is a good financial fit when the time comes.”