How to Save Money for College

By Thursday Bram on 21 October 2009 (Updated 6 April 2010) 0 comments
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The cost of attending college continues to rise. In order to handle those costs, you may be considering saving for your child's college education long before he or she is ready to enroll in school. There are several different options for building a college fund that will cover part or all of a student's college expenses. It can be confusing to sort through the different savings and investment options. Deciding between alternatives like a prepaid tuition plan or a savings bond isn't always a clear choice.

In order to make that decision, it's crucial to understand the options you have, as well as how each option affects your finances now and your child's financial aid when he or she is ready to start college. Section 529 plans, Coverdell Education Savings Accounts, UGMA / UTMA custodial accounts and savings bonds can all be good options when it comes to saving for college, but it's important to find the best option for you and your family.

Section 529 Plans

Section 529 plans offer a way to save money for future college expenses with some very significant tax advantages. There are two types of Section 529 plans. You can choose a prepaid plan, which allows you to purchase tuition credits at today's rates, or you can use a savings plan, which allows you to invest your savings in mutual funds. In either case, when your child is ready to withdraw money from the 529 plan, the withdrawal will not be subject to federal income tax, as long as the money is spent on college expenses.

A prepaid plan can be a more useful option if you're taking a long-term approach to saving for college. By saving money through a prepaid Section 529 plan, the biggest benefit comes if the cost of tuition rises significantly. Tuition costs do tend to rise every year, but in the short-term, they may not rise enough to make prepaying tuition the best option. In contrast, a Section 529 savings plan allows you to invest in a mutual fund — your savings earn money as long as the market is doing well. However, many investments can earn more than those chosen for Section 529 plans. Section 529 plans have low risks associated with them, but also have lower earnings.

That low risk comes out of the fact that both types of Section 529 plans are usually run by state governments. Any money you save through a Section 529 plan is generally considered very safe — the state running the plan would have to go bankrupt for your savings to be in danger. The only safer savings option is a U.S. government bond. Many states offer other incentives for choosing a Section 529 plan, as well. Some states go so far as to offer to match your contributions to your child's Section 529 plan, while others offer deductions or credits on your state income tax return.

Coverdell Education Savings Accounts

Another savings account option is a Coverdell Education Savings Account (also known as a Coverdell ESA or an Education IRA). A Coverdell ESA can offer you more flexibility in saving for college than a Section 529 plan, although there are some limitations. With a Coverdell ESA, you are limited to contributing $2,000 each year to the account. However, you can use money saved in a Coverdell ESA for far more education expenses, including tuition while your child is still in elementary school, middle school, or high school. If you have two or more children, you may find a Coverdell ESA ideal: in the event that one of your children does not need the full amount you've saved for his or her college, you can transfer money to the Coverdell account of another family member.

If you plan to save more than $2,000 per year for your child's savings, a Coverdell ESA may not be the best option. However, it does have certain tax advantages that can make it more useful, despite the limits on savings. Any money that you invest grows tax deferred until you're ready to withdraw it — at which time, you can take it out tax free to use on education expenses. You can also choose investments for your child's Coverdell ESA from a much wider list of choices than for a Section 529 plan. Investments can include stocks, bonds, and mutual funds, which may provide an opportunity for a better rate of growth.

UGMA / UTMA Custodial Accounts

In the past, Uniform Transfers to Minors and Uniform Gifts to Minors custodial accounts were a popular method to save for college. In order to create an UGMA or UTMA custodial account, you or another relative can open an account in your child's name. You can save money in your child's name and invest it so that it will continue to grow until he or she is ready to begin college. However, there are now few tax advantages associated with using a custodial account, compared to a Section 529 plan or a Coverdell ESA. Until 2006, accounts in a minor's name were taxed at the minor's rate, rather than his or her parents. Now, however, children cannot take advantage of their lower tax rates until they reach the age of 18. You may also face taxes on any earnings from investments in a custodial account, which is not true of other college savings options.

There is another drawback to using an UGMA or UTMA custodial account. While colleges do not count Section 529 plans or Coverdell ESAs as assets of a student applying for financial aid, custodial accounts are considered assets. That means that your child would receive less financial aid than may be necessary if the bulk of his or her college savings is in a custodial account.

Series I and Series EE Savings Bonds

While savings bonds do not necessarily provide the largest return on an investment if you're looking to increase the amount of money your child has available for college, they are one of the safest savings options out there. Series EE and I bonds, in particular, can be useful in saving for college. When you cash a Series EE or I bond and use the money to pay for college expenses, the money you've earned on the bond is tax exempt, from both federal and state taxation.

Buying bonds is one of the simplest ways to save money for college. You don't need to open any kind of investment account in order to purchase a U.S. savings bond. In fact, you can buy them online through TreasuryDirect.gov. If simplicity is important, Series I and Series EE savings bonds may be a useful option for you.

Making the Decision

According to the College Board, the current average cost of a year at a private college is $25,143. That number is projected to continue to rise — but that doesn't mean that you need to plan to pay all of it. Depending on your child's educational plans, options like attending a public university can bring down the price tag dramatically, as can starting at a two-year school and making the switch to a four-year school later on.

Financial aid is also available for most families. Currently more than $143 billion is available in financial aid. While it's probably not a good idea to assume financial aid can pay for the full costs of college, it is reasonable to save what you can for your son or daughter's college expenses with the expectation that some student loans and other financial aid options will be available for your child.

However, colleges do take any college savings accounts you've used to save money for your child into account when determining how much financial aid to offer him or her. Each school can choose how to handle specific types of accounts. Section 529 plans and Coverdell ESAs are often listed as parental assets, which does allow students to receive more financial aid. UGMA and UTMA custodial accounts are usually considered to be student assets, however, reducing financial aid far beyond what a parental asset might. If you purchase saving bonds in your child's name, those bonds may be considered student assets; however, you can purchase Series I and Series EE savings bonds in your own name and still receive the tax advantages offered by using them for college expenses.

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