Saving for College: How to Start a College Fund for Your Kids

A few staggering stats to get your day started:

● Americans have over $1.5 trillion in student loan debt

● In 15 years, a four-year degree will cost about $300,000 on average

If those numbers make you feel either angry or depressed, I completely understand. It’s honestly hard for me to offer up this information, as it makes writing this type of article feel a little hopeless. However, the cycle of debt doesn’t have to go on and I’m going to do everything I can to help the next generation of students get educated on the cost of an education.

We don’t need more evidence to understand that massive student loans hurt young graduates. Careers and families get put on hold in order to pay ridiculous monthly fees and outrageous interest charges. Still, for most high school graduates, the choice feels like accepting endless debt or going through life without a college degree. And, while I support anyone who has professional ambitions that don’t require higher education, I hate the idea of someone skipping college only because they can’t afford it.

While we don’t know when the bubble will burst and what might happen to tuition costs going forward, we do know that saving for college in advance will have a huge impact on what a person can afford. The ship may have already sailed on your bachelor’s or master’s degree, but it’s never too late to start tucking money aside in a college fund for your kids. There is, however, some debate around what the best way to save for college might be.

Discerning between these options will make a big difference when it comes to how you plan for a son’s or daughter’s education. Some of them are fairly similar, but the slight discrepancies become very noticeable when you’re talking about thousands and thousands of dollars. Let’s dive in!

1. 529 Plans

For anyone saving money exclusively for a qualified secondary education, the 529 plan is considered the gold standard. Essentially, this type of investing account functions like a retirement account, but with all the tax benefits coming into play when the funds are used for college.

From the Securities and Exchange Commission: “529 plans, legally known as “qualified tuition plans”, are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.” With government backing and oversight, you won’t find a much safer place to stash money meant for a future education. Should you try to use the money for something else, tax exemptions disappear and a penalty gets applied.

Within the 529 umbrella there are two options:

● Prepaid 529 plan

● Savings 529 plan

The prepaid plans allow you to lock in today’s prices for a future degree. By purchasing tuition credits sold at 2023 rates, you theoretically spend less when you send your child to school in 15 or so years. While we can’t predict college prices with guaranteed accuracy, it’s a safe bet that inflation won’t go away and higher education won’t become completely free.

A 529 college savings plan will probably feel a little safer to the average parent, as you watch money grow in an investment account the same way you do with retirement funds. The most enticing part of the 529 plan is the tax advantage; watching interest compound on untaxed dollars can have you feeling really good about the cash you put into a college fund for your kids.

Both the 529 college savings plan and the prepaid option have plenty of upside. The trickiest part of your 529 selection might be the provider, as these programs are state-run but often operate through a third party that could charge unexpected fees. When shopping for your plan, make sure you indicate which state’s 529 plan you’ll be contributing to and find out who handles the account. If you want some guidance to get you started, NerdWallet has a useful breakdown of both prepaid and savings plans by state.

The one con with a 529 plan is that it leaves you with little recourse if the intended beneficiary decides he or she doesn’t want to go to college. Your investment won’t be lost, but you will forfeit the tax benefits. For families determined to send kids to college and utilize higher education as part of a career path, a 529 plan makes a lot of sense. For anyone a little less sure about what the future will hold, it’s understandable if this type of money management seems a little precarious. And that’s exactly why I’ve got four more options for how you can save for school.

2. Roth IRA

The scariest thing about an IRA is not being able to access your money without a penalty. However, these funds can be used penalty-free under certain exceptions. Approved tuition fees are one of those allowances.

The atypical route of using an IRA as a college investment account forces you to jump over a few more hurdles than a 529 plan, but it also provides an excellent safety net should you or your child decide not to use the funds for college. There’s nothing wrong with leaving retirement money right where it is and having more when it comes time to retire.

People have discovered the usefulness of IRAs as college funds for kids out of unplanned necessity. Parents simply had no better option than dipping into their retirement to help cover the soaring tuition costs that their children and grandchildren are being forced to deal with. In general, I advise against pulling out money that didn’t have the original intention of covering education expenses. It might seem like a nice thing to do in the moment, but when it delays your retirement and makes it harder to provide financial assistance to others later in life, you aren’t really doing anyone any favors.

Instead of swapping your own retirement account for a child’s education, you can open a second Roth IRA as an intentional college savings account. Put money into it as you would a 529 plan and then withdraw money without penalty when it’s time to pay qualified tuition costs. You can use only the contributed funds if you want to avoid tax liabilities, not the earnings, and you’ll only avoid tax liabilities with a Roth IRA – a traditional IRA loses that benefit.

Of course, there are a few other reasons why an IRA isn’t an even-money replacement for a 529. For starters, the funds can only cover a student enrolled more than part-time, whereas 529 plans will cover all qualified expenses no matter how many units are taken in a given semester. IRAs also have a greater effect on financial aid eligibility, while 529s don’t weigh as heavily on that assessment.

Another unavoidable issue with using an IRA to save for school is the contribution limit. Since you can only contribute $5,500 each year before you turn 50, there’s no way to quickly grow an IRA. Putting aside the maximum each year for 18 years leaves you with $99,000 in contributed funds, less than half of what you need to cover four years of projected cost at the average school.

There’s no question that a 529 makes more sense when saving for college. The main reason you might consider an IRA instead is if you have doubts about whether college will be the course your child takes. A decade ago, I don’t think this conversation would merit a second thought. Now, with so many young professionals starting families while trying to pay down mountains of student loan debt, higher education is looked at through a different lens.

Personally, I think the 529 plan still makes a lot of sense. However, if it makes you nervous and you’d feel more confident building up a Roth IRA that may or may not end up going towards an education, there’s a lot of sense to that approach.

3. Custodial Account

This third option sort of bridges the gap between the previous two, offering certain benefits from both IRAs and 529 plans but losing some of the tax incentives. I’m starting to think a Venn diagram will be the best way to explain this subject to people, but I’m better at writing articles than drawing pictures so here we are.

When saving for college, a custodial account most closely represents a 529 in that parents open an account in the name of a minor and then use that investment vehicle until said minor turns 18 or 21, depending on the legal adult age in that person’s state. The custodian of the account cannot access these funds for personal use, so every dime that goes in has to benefit the minor. Contributions are irrevocable, but that shouldn’t be an issue for anyone trying to set their child up for success.

You’ll hear custodial accounts referred to as UGMAs and UTMAs, standing for the Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act, respectively. Which type you choose will likely depend on the state you live in, and the major difference is the types of assets you can contribute.

UTMAs allow for a wider variety of contributions, including everything from real estate to rare collectibles, making this the optimal choice for the experienced investor. UGMAs are narrower in scope but still offer much more flexibility than a 529 plan, which is the primary reason to choose a custodial account. The other pros include:

● No contribution or income limits

● Funds can be used for almost anything benefitting the minor

● Accounts are offered by numerous banks and brokers

Since you can fill a custodial account with a wide range of assets without any contribution limits, this provides the best opportunity to amass wealth between the time a child is born and when he or she turns 18. The biggest deterrent from using a UTMA or UGMA is the lack of tax deferment. However, the deposited funds are taxed at the child rate, meaning a super-wealthy custodian will still get a bit of a tax break by putting aside money for their income-less child.

Like an IRA, this option is inferior to a 529 when it comes to saving for college specifically. That said, it’s a much better option for a young adult who decides to open up a business straight out of high school instead of pursuing a degree. If the goal is to grow wealth and maintain flexibility, you might want to eat the taxes and invest strategically in a custodial account.

4. Savings Account

If your head is spinning as you try to decipher the above, there’s no shame in playing it safe. Putting money into savings and earning a little bit of interest makes the most sense for people with fluctuating finances, and you can always roll savings into a custodial account or a 529 plan in the future if that seems like the right choice.

With the number of online banks that offer decent interest rates, directing a steady stream of cash into a savings account isn’t a bad idea at all. My advice tends toward investing and putting money to work, but when you’re trying to build up capital for something specific and you’re unsure of what type of account will get the job done, aim for the best version of liquidity you can find.

Assuming you open a savings account when your child is still a child, I’d make sure to reassess each year as your financial situation evolves, the college landscape changes, and your child’s interests become more concrete. The path forward may stay murky, but it could also start to crystallize and make clear that a 529 plan makes the most sense. Until such an epiphany comes along, keep putting money in savings so it’ll be there for whatever the future may hold.

5. Skip It

Before you gasp in shock, this option isn’t as nihilistic as it sounds. While saving up for college makes a lot of sense and serves as an excellent way for parents to provide for their kids, it comes at a cost. The money set aside for absurdly high tuition can go toward other, more consequential needs.

As mentioned earlier, sacrificing your retirement account for your child’s education isn’t a smart trade. While we do want the best for our children and pray that their lives will be better than ours, you can’t be shortsighted in that desire. If you use retirement money to pay for your kid’s degree, you might end up leaning on that kid for financial assistance when you’re in your 60s or 70s, and no one wants that.

You also need to consider the actual value of what you’re paying for. You don’t have to look far to find hugely successful people who went to affordable community colleges or skipped a college degree entirely. Young adults can learn a lot about opportunity and sensible spending by opting not to go to a fancy school, or by applying for scholarships and working part-time to cover extra costs.

The current student debt crisis is due in large part to a generation of students thinking college was the only option, and lenders making those students feel like a bachelor’s degree was worth six figures of debt. As you consider what you want for your children, ponder the lessons you think they should take away from the college conundrum, and how you can best guide them. There are plenty of options for saving for college, but there are also very logical reasons why that might not be the best option for you and your family.

If you’re on the fence about saving for school, I say go ahead and save. Whether it’s a 529, a Roth IRA, or a custodial account, you’re ensuring that money is available for future use. Give some serious thought to what kind of flexibility you want, then start filling an account so you and your kids will have options when the time comes.

Make it happen!

Taylor & Megan Kovar

The Money Couple