However, a savings account may not yield you the same return on investment or tax breaks as you could get from a 529 plan, Coverdell ESA, or other college savings strategy. While a savings account at your bank or credit union may be an easy place to start, weigh all your options to find the best way to save for college for you and your family.
Considerations for Saving for College
When considering the best way to save for college, a number of factors come into play:
Security and risk: Having a safe and secure place to stash your savings can give you peace of mind. You may also wish to pursue a low-risk strategy that will preserve your savings through ups and downs in the markets. Capital preservation vs. capital gains: A savings account prioritizes capital preservation over capital gains. It’s designed to help you keep money rather than to maximize your return on investment. Annual percentage yield (APY): Savings accounts tend to earn modest interest over time. However, this APY may not be high enough to keep up with the rate of inflation. Withdrawal restrictions: Some college savings accounts require you to spend your savings on qualifying educational expenses, while general savings accounts usually have no restrictions on how you use your withdrawals. Tax benefits: Some types of accounts offer special tax perks for college savings. With a general savings account, any interest you earn will be treated as taxable income.
Pros and Cons of Using a Savings Account To Pay for College
Pros Explained
Insured for up to $250,000: If you open a savings account at an FDIC-insured bank or NCUA-insured credit union, your deposits will be protected up to $250,000. Earns a modest amount of interest: Savings accounts offer interest earnings on your deposits, although APYs are generally low. As of September, the average national savings account rate was 0.17%. Few withdrawal restrictions: While some college savings plans require that you spend the money on qualifying educational expenses, you can spend your savings account funds on whatever you like.
Cons Explained
Low return on investment (ROI): With the national rate at 0.17% and rate cap (highest rate available) at 3.08% as of September 2022, savings account yields are fairly low. Your ROI could be much higher with a different type of investment account. APY may not keep up with inflation: The low APY of a savings account could also mean your savings loses value over time due to inflation. In August 2022, the inflation rate was 8.3%, near 40 year highs. Lacks tax advantages: Any interest you earn in your savings account is taxable and must be reported to the IRS. A 529 plan, on the other hand, which is designed for college savings, offers tax-free growth and withdrawals as long as you spend the money on qualifying education expenses.
Alternative Places To Save for College
A savings account is not your only option when it comes to saving for college, and it’s probably not the best way to save for college. Here are some alternative strategies you can use to help cover your child’s future education costs.
529 Plans
A 529 plan is a tax-advantaged, low-risk investment account designed specifically to help you save for college. Like with a Roth IRA, you contribute post-tax dollars to a 529 plan, and your investments grow tax-free. You also won’t have to pay taxes on your withdrawals as long as you spend them on qualifying education expenses such as tuition, fees, housing, meal plans, books, and supplies. The maximum amount you can save will vary by plan, but it typically maxes out between $235,000 and $529,000. There are two main types of 529 plans you can choose:
Education savings account: This is a general savings account that you can draw on to pay for college expenses.Prepaid tuition plan: This account lets you pre-purchase credits at a college (usually in-state and public) at today’s rates.
While 529 plans offer more tax advantages than a savings account, they also have more withdrawal restrictions. If you use the money on non-educational expenses, you’ll have to pay a 10% penalty.
Coverdell ESA
Similar to a 529 plan, a Coverdell Education Savings Account (ESA) allows tax-deferred growth and tax-free withdrawals for qualifying education expenses. It can be used to pay for elementary- and secondary-school expenses, as well as higher-education expenses. Like a 529, using the money on other expenses will trigger a 10% penalty and tax bill. Unlike a 529 plan, however, there are income limits to access a Coverdell ESA. To contribute, your modified adjusted gross income (MAGI) must be less than $110,000 as a single filer or $220,000 as a married couple filing jointly. Plus, the maximum annual amount you can contribute per student is $2,000.
Roth IRA
While a Roth IRA is designed to help you save for retirement, it could be part of your college savings strategy. Similar to a 529 plan or Coverdell ESA, you contribute post-tax dollars to a Roth IRA. Your earnings grow tax-free, and you can make tax-free qualifying withdrawals. Typically, you need to wait until you’re age 59½ to withdraw your money without penalty. However, you can draw on your funds tax-free if you use them for qualifying education expenses. You can take out your contributions without penalty at any time since you already paid taxes on the amount. Roth IRAs do have a few limitations. You can’t contribute if you make more than $144,000 as a single filer or $214,000 as a married couple filing jointly. The maximum contribution limit is $6,000 per year, or $7,000 if you’re 50 or older.
Mutual Funds
A mutual fund is another type of diversified investment that typically contains a mix of stocks, bonds, and other investment types. Depending on how your investments perform, you could see a return on investment on your savings over the long term. Unlike a 529 plan, there are no restrictions on what you spend your mutual fund savings on, nor is there typically a limit on how much you can invest. A downside of mutual funds, however, is that your earnings will be subject to income taxes. Plus, you’ll need to pay taxes on any capital gains when you sell shares.
UGMA and UTMA Custodial Accounts
Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts are brokerage accounts you can open on behalf of your child or grandchild. You manage the account until your child turns a certain age. At this point, your beneficiary can spend the funds on college or other expenses.
US Savings Bonds
If you’re looking for a low-risk investment, qualifying U.S. savings bonds are an option. While they may not offer the highest ROI, they’re typically seen as safe and secure. You may also get a tax break if you use the funds on higher-education expenses, although this interest exclusion is phased out at higher incomes. You’ll only get the tax benefits if the bond is issued in your name (rather than your child’s), since they require that the bond’s owner be 24 years old before the issue date.
