You're ready to start saving, but where should you put your money? It's smart to consider tax-advantaged strategies whenever possible. Here are some options.
529 plans are one of the most popular tax-advantaged college savings options. Contributions accumulate tax deferred, and withdrawals are tax-free at the federal level if the money is used for qualified education expenses. States may also offer their own tax advantages. (For withdrawals not used for qualified expenses, earnings are subject to income tax and a 10% federal penalty.) 529 plans are open to anyone, and lifetime contribution limits are high, typically $350,000 and up (limits vary by state). In 2022, lump-sum gifting up to $80,000 is allowed ($160,000 for joint gifts) with no gift tax implications if certain requirements are met. There are two types of 529 plans: savings plans and prepaid tuition plans. A 529 savings plan is an individual investment account similar to a 401(k) plan where you direct your contributions to one or more of the plan's investment portfolios. Funds in the account can be used to pay tuition, fees, room and board, books, and supplies at any accredited college in the United States or abroad. Funds can also be used to pay K-12 tuition expenses, up to $10,000 per year. By contrast, the less common 529 prepaid tuition plan allows you to purchase college tuition credits at today's prices for use in the future at a limited group of colleges that participate in the plan, typically in-state public colleges.
A Coverdell education savings account (ESA) is a tax-advantaged education savings vehicle that lets you contribute up to $2,000 per year for a beneficiary's K-12 or college expenses. Your contributions grow tax deferred, and earnings are tax-free at the federal level if the money is used for qualified education expenses. You have complete control over the investments you hold in the account, but there are income restrictions on who can participate, and the $2,000 annual contribution limit isn't likely to put much of a dent in college expenses.
Custodial account (UTMA/UGMA)
A custodial account allows a minor to hold investment assets in his or her own name with an adult as custodian. All contributions to the account are irrevocable gifts to your child, and assets in the account can be used to pay for college. When your child turns 18 or 21 (depending on state law), he or she will gain control of the account. Earnings and capital gains generated by the account are taxed to your child each year under the "kiddie tax" rules. Under the kiddie tax rules, a child's unearned income over a certain threshold ($2,300 in 2022) is taxed at parent income tax rates.
Though technically not a college savings option, some parents use Roth IRAs to save and pay for college. Contributions to a Roth IRA can be withdrawn at any time and are always tax-free. For parents age 59½ and older, a withdrawal of earnings is also tax-free if the account has been open for at least five years. For parents younger than 59½, a withdrawal of earnings — typically subject to income tax and a 10% premature distribution penalty — is spared the 10% penalty if the withdrawal is used to pay for a child's college expenses.
Many families rely on some form of financial aid to pay for college, which may include loans, grants, scholarships, and work-study. Financial aid can be based on financial need or on merit. To determine financial need, the federal government and colleges look primarily at your family's income. To get an idea of how much grant aid your child might be eligible for at a particular college, you can use a net price calculator, which is available on every college website. The bottom line, though, is to beware of too much borrowing to pay for college. Excessive student loan debt — and parent debt — can negatively affect borrowers for years. The more you save now, the less you and your child will potentially need to borrow later.