College savings accounts have grown in popularity over the years, and choosing the right one for your child can be overwhelming. There are so many options or configurations that it’s easy to have analysis paralysis. The most important thing is to do your research and make sure you consider all of a plan’s pros and cons.
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Types of College Savings Accounts
529 plans are the traditional way to save for a child’s education, and they offer a nice amount of flexibility and growth potential, but they aren’t the only option. Many people choose to supplement college savings using a Roth IRA because your child can use that money for non-education-related expenses and anything leftover can give them a headstart on their own retirement planning. Both of these options use after-tax dollars that are either invested in the stock market or used to purchase other vehicles like savings bonds to grow the principal balance using compound interest.
529 Plans
529 plans are state sponsored, and you can belong to any state’s program, not just the state you live in, though there are often tax incentives for in-state residents using their state’s plan. 529 plans do not give you a federal income tax break, and there are no age or income contribution limits as long as you follow IRS guidelines.
529 plans consist of two types:
- Prepaid Tuition Plan: A prepaid tuition plan allows users to purchase credits to a specific instate college or university. These plans are guaranteed by the particular state you are buying them from and are not federally insured. Suppose your child decides to attend a different school than the plan designates. In that case, your credits may not offer the same value on tuition expenses. These plans generally account for tuition only and cannot be used for room and board or other educational costs.
- Educational Savings Account: ESAs are what we generally think of when we talk about 529 plans. They take after-tax dollars and invest them in various stock market options of your choosing (within plan limits), including mutual funds, target-date funds, or exchange-traded funds. These plans allow you to use funds for qualified education expenses, including tuition, fees, books and other necessary school purchases such as computers. Some even allow you to put the money toward living expenses.
Roth IRAs
Many people supplement their 529 plan with a Roth individual retirement account set aside specifically for education expenses. Roth IRAs are usually thought of as retirement accounts, but you can create one at any time as long as you have earned income and contribute amounts up to the yearly maximum ($6,000 in 2021).
The benefit of using a Roth IRA is that you can withdraw your contributions at any time, tax and penalty-free, which can be a great option if you find yourself in need of funds for non-education-related expenses. Once you (or the account holder) reach age 59 1/2 (and have held the account for at least five years), you can also withdraw your earnings tax and penalty-free.
Roth IRAs can be a great supplement to a college savings account, but talk with a financial planner about what works best for your situation.
Things to Consider When Choosing a College Savings Account
Regardless of the plan(s) you choose for college saving, it’s essential to consider all the benefits and drawbacks of each. Here are some things to look for when you start to research:
Look at fees and expenses.
It’s essential to determine the costs and other expenses associated with each type of account. Each plan will charge various fees, including enrollment, account maintenance and a brokerage fee if you have a broker managing the account. Review the fee schedule in the account literature and pay attention to how plan costs increase as the account balance grows.
Weigh the tax benefits.
Different types of plans offer different tax benefits, and it’s important to know what you can expect, especially in conjunction with the fees and expenses. 529 plans often provide you with a state income tax break if you choose your state’s plan. Do your research and talk to a financial adviser to figure out the best option for you.
Consider your timeline.
Unlike with retirement accounts, which you ideally start in your 20s or 30s and contribute to for the next 30 or 40 years, the money in a college savings account is going to be needed much sooner, generally within the next 10 to 18 years, depending on when you start an account.
This usually means you want to choose something with aggressive growth to get the most out of your contributed dollars, but be sure that you can tolerate the risk factor—if the stock market hits a low period, your earnings, and possibly even your principal might be lost.
Understand the factors of transferring beneficiaries.
529 plans allow you to move any unused funds from one child’s account into another eligible family member’s account, but there are rules and caveats, so be aware of the rules that apply to you before you make any big decisions. A Roth IRA has rollover and inheritance rules that you need to account for before proceeding, and they can get pretty complicated, depending on how the account is set up.
Saving for your child’s education is a daunting task and can quickly become overwhelming, but ultimately, it’s important to get started so your money has the best chance to grow. Make sure you do your research, talk to a certified financial planner, and consider all the variables inherent to your situation. Although there are some pros and cons to each type of college savings account, it’s generally best to pick a plan that will work for you in most ways and start contributing so your child’s dreams don’t become a financial nightmare.
