Saving for Education: 529 plans, custodial accounts, Coverdell, Roth IRA

By Jessica Dosseh

It's never too late (or too early) to start saving for college. A good rule of thumb is to save at least $250 per month or even the smallest amount in a tax-advantaged investment account.

Find a plan that works best for you and for your children. Take time to consider how each plan affects future financial aid.

  • 529 plan — The contribution limit is $16,000 and is restricted to qualified education expenses.

  • Custodial accounts — There is no contribution limit, and it is not restricted to educational use.

  • Coverdell ESA — The contribution limit is $2,000. It covers higher education expenses, as well as elementary and secondary education expenses.

  • Traditional and Roth IRAs — This is a general investment account. You can withdraw your money without paying the 10% additional tax to pay for qualified higher education expenses.


Saving for an Education

If you are a parent or planning to become a parent, planning for your kids' education can be one of the most expensive items on your to-do list. According to the College Savings Plans Network, it costs parents, on average, well over $300,000 to send their kids to school. And, in 17 years, the most expensive colleges are projected to cost more than half a million dollars. This financial obligation can seem overwhelming – college costs are continuing to increase at about twice the annual inflation rate.

Nevertheless, saving even the smallest amount to a tax-advantaged investment account would end up helping your future offspring significantly. Here are strategies you can employ to reduce the emotional and financial stress of college costs.

It is never too early to start saving for higher education.

Education is one of the most important tools we have as individuals, but with the rise in cost, it can seem a bit inaccessible. For most families, paying for college looks like collecting financial aid, scholarships, grants, and any leftover spare change. But instead of keeping your spare change in your bank account, consider putting it into a tax-advantaged investment account so that it can compound and grow over time.

The more time the account has to grow, the more money your kids will have available when they need it for their education.

Here are some options to get started saving for children’s future.

  • 529 plan

  • Custodial accounts

  • Coverdell ESA

  • Traditional and Roth IRAs

Find a plan that works best for you and for your children.

When it comes to saving, the first thing you need to ask yourself is if you want your child to use the amount you save towards an education specifically, or if you want them to have funds for an open-ended future.

529 plan

A 529 plan is a plan that allows you to contribute up to $16,000 in after-tax dollars towards education. All withdrawals from the 529 plan are free from federal income tax as long as they are used for qualified education expenses.

Money in a 529 college savings plan that the student or the parent owns is reported as a parent asset on the FAFSA, and distributions are ignored.

If you have the means to do so, each parent, guardian, or family member can contribute five years of gifts upfront for each child without being subject to the gift tax.

This means you, your parents, or any other family member could contribute $80,000 each towards your children's education fund while they are still young and let that money grow to cover their education expenses. This process can be a bit complicated, so please refer to professional tax advisors for more details about the process.

Your state may also offer additional tax benefits such as tax credits or deductions for 529 plan contributions.

Custodial accounts

Custodial accounts allow you to put money and/or assets in a trust for a minor child or grandchild. This will enable you to manage the recipient's account until they reach the age of maturity — 18 to 21, depending on the state. This account is not restricted to educational use and can be used in whatever manner the recipient chooses to use it. This type of account is classified as the recipient's assets, which could affect their eligibility for financial aid.

There are no contribution limits, but you can set a personal limit of $16,000 or $32,000 per married couple to avoid the gift tax.

Coverdell ESA.

A Coverdell Education Savings Account (ESA) can be set up at a bank or brokerage firm to help pay the qualified education expenses; otherwise, there is a 10% penalty on earnings. This savings plan is similar to a 529 plan but covers higher education expenses, as well as elementary and secondary education expenses.

With a Coverdell ESA, all contributions must be made before the recipient turns 18 years old.

The maximum contribution per recipient is limited to $2,000 per year, and you must make less than $110,000 as a single filer or $220,000 as a married couple filing jointly.

Traditional and Roth IRAs.

You can open up a Traditional and Roth IRA to hold investments such as stocks, bonds, and mutual funds to grow your money. Generally, if you withdraw from your IRA before you are 59½ years old, you will owe a 10% additional tax on the early distribution. However, you can withdraw your money without paying the 10% additional tax to pay for qualified higher education expenses for yourself, your spouse, your children, or grandchildren in the year the withdrawal is made.

One option to avoid withdrawals directly from your personal IRA would be to open up an IRA in your child's name; however, your child will need to have earned income and cannot contribute more than they have earned. If your child earns $100 from a summer job, you can make a $100 contribution to their Roth IRA.

One of the major benefits of using a Roth IRA as an education savings account is that money in a qualified retirement plan is not reported as an asset on the FAFSA; however, distributions from the student's Roth IRA count as income which must be reported on the FAFSA. A potential workaround would be to have the student wait until after graduation to take the distribution to pay down student loan debt.

Quick overview.

The 1/3 plan.

Suppose you are not able to make consistent contributions to a college fund; you might want to use the 1/3 rule. To pay for college, one-third of the cost might come from past income (savings), one-third from current income, and one-third from future income (loans).

The idea is to start somewhere.

How does saving for education affect your financial aid?

If you are saving for your children's future, you may not have to worry about financial aid. Nevertheless, it's important to keep in mind that financial aid eligibility is based on the income and assets of both the student and parents and counts both taxable and untaxed income as part of total income.

Gift contributions within a 529 or custodial plan may get counted twice in the financial aid formulas, once as untaxed income to the student and once as an asset.

The federal financial-aid formula expects students to contribute 20% of their savings, versus a maximum of 5.6% of savings for the parents.

FAFSA uses income information from the calendar year that is two years prior to the academic year. Thus, 2022-2023 FAFSA will be based on 2020 income information. So, if you need a workaround when it comes to declaring gifts as income on your FAFSA, consider holding off on any major gift contributions until two years before the student fills out their FAFSA.

Calculate how much you need to save for education.

There is no doubt that college is expensive and tuition and fees tend to grow faster than the total cost of attendance, including room and board. College costs inflate at a rate of about 6% but could potentially be lower at private non-profit four-year colleges than at public four-year colleges, partly because private college costs are higher.

You might not be able to predict the specific college your child will attend, but you could set goals for an in-state public or private four-year college.

According to the College Board's annual Trends in College Pricing 2021 report an average cost of attendance (tuition, fees, room, and board) would be:

  • Public four-year college (In-State): $27,330

  • Public four-year college (Out-of-State): $44,150

  • Private Non-Profit four-year college: $55,800

Estimated Annual Future College Costs (at a steady 6% college cost inflation rate)

A good rule of thumb is to save at least $250 per month for an in-state public four-year college, $450 per month for an out-of-state public four-year college, and $550 per month for a private non-profit four-year college, from birth to college enrollment.

Start by taking baby steps.

Break up your college savings goal into baby steps so you can start saving monthly instead of one large lump sum.

Start with whatever you can, then increase the amount gradually. Once you start saving, you'll find it easier to increase the amount you save per month.

For more help, use a college-saving calculator.\

It's never too late (or too early) to start saving for college since every dollar you save is a dollar less you'll have to borrow. But, it is easier to save the sooner you start since the monthly contributions will be smaller, and there's more time for the earnings to compound.