I’ve been having a lot of fun (yes, really) the last couple of years researching college savings plans and investment tools. I’m sharing what I’ve learned for two reasons (1) I want to be able to look back and recall this info and here it’s convenient, and (2) many parents put off this decision until their kids are already in school, and by then they’ve missed out on several years of a growing investment. So, given that a parent decides to begin saving for their kiddo’s college (or future), where do they start? Here are the options:

1) A 529 savings plan

Benefits: this type of investment grows tax-free (contributions to the account aren’t deducted from your federal taxes, but distributions to pay for school aren’t taxed – yay). Also, the beneficiary can be changed. This is handy if one child decides not to attend college, the money can be used for another child (ouch). Or, the money may be rolled over into an IRA when the child reaches a certain age (not positive on this one, I just remember reading it somewhere). One benefit that many parents find attractive about a 529 is that the account remains under the control of the parent, not the beneficiary. So, if Johnny goes nuts and wants to spend his college savings at the University of Underwater Basket Weaving, mom and dad have the power to keep his hands off the investment. Many 529 plans also offer a “prepaid tuition” option, where contributions to the account go toward purchasing credits to be used in the future (but purchased at the current tuition price). With the increasing cost of tuition, this is an attractive account (although prepaid plans generally grow at a slower rate than their regular 529 counterparts).

2) Coverdell ESA

Benefits: Earnings grow tax-free. The biggest advantage that I see from this account is that withdrawals can be used toward not only college expenses, but qualified k-12 expenses as well. This puts a Coverdell ESA as a good option for parents who are planning to put their kids in a private K-12 school. If you’re going to pay for the schooling costs anyway, why not get some benefit out of it by pulling it out of a Coverdell Account? Contributions to the account are limited to $2000 per year. The account can also be transferred to a different child.

3) UGMA/UTMA (custodial account)

The investment options here are endless, as a UGMA/UTMA is basically just a mutual fund (or portfolio of funds) that is opened in a child’s name. The scariest thing about this type of account for many parents is that a new beneficiary can’t be named on the account, and once the child reaches the age of majority (usually 18 or 21), the money is theirs to do with as they please. The greatest benefit of this type of account is that the money is not restricted to college costs. It can be used for anything (gambling on the stock market, down payment on a house, mail-order bride). Because of this flexibility, the tax benefits are not as great as that of the 529, but it still offers some benefit over just opening a portfolio in the parent’s name. The first $900 of unearned income (interest) is tax-exempt, the next $900 of unearned income is taxed at the child’s rate, and the rest is taxed at the parent’s rate.

4) IRA

I’ve read a lot of conflicting advice about using this tool for college purposes. If you’re interested, do the research. Some people like this option, but I’ve run out of research time, so you’ll have to do your own 🙂

Things to consider when choosing a plan:

  • Is it important that I be able to change the beneficiary? (If yes, then don’t choose a UGMA/UTMA)
  • Am I comfortable with my child using the investment as they wish after reaching the age of majority? (If No, then a UGMA/UTMA is out)
  • Do I want to use this investment for any k-12 expenses? (If so, consider a Coverdell)
  • Do I want my child to be able to use this investment for more than just college? (If yes, consider a UGMA/UTMA)
  • Do I want my child to be eligible for Federal Financial Aid? (If yes, then research these considerations, some investments count as the parent’s asset, and some the child’s)
For the next post I’ll present the Maxwell Family college savings plan, for your reading pleasure…