Summary: In this article you’ll learn about the eight best college savings plans. Topics include the impact of student loan debt, options for education savings accounts, the pros and cons of each plan, who qualifies and determining which strategy works best for your family.
Introduction
The continually rising cost of higher education, paired with limited savings by parents and the increased earning power of a college degree, has resulted in unprecedented amounts of student loan debt. Many recent and not-so-recent graduates find themselves buried in student loan debt, which in turn, impacts their ability to buy a house and start a family.
In fact, the average student loan debt has become so high that many Millennials are choosing to enter the workforce instead of attending college. As of 2018, student loan debt has reached an all-time high of $1.5 Trillion, collectively.
For more information on student loan debt and FAQs, check out my article [Should I Pay Off My Student Loan Debt or Invest] here.
While the cost of college tuition is expected to continue upward, the best thing parents, grandparents or guardians can do for their children is to start saving for their future education as soon as possible. The earlier you open and start actively contributing to a college savings plan, the better off you and your children will be.
8 Best College Savings Plan Options
In the following sections you’ll learn about the eight best college savings plan options, along with advantages and disadvantages associated with each plan.
1) 529 College Savings Account
Probably the most well-known college savings account. The 529 plan is a state or institution-sponsored education savings account that offers tax advantages. Because there are so many 529 plans available, it will be important to compare rates, fees, and rules before making a decision.
The Pros
- Higher contribution rates (varies by state)
- No or minimal income limits or restrictions based upon age
- Grows tax-free
The Cons
- Some restrictions may apply when transferring 529 Plan funds to a different child’s name
- Impacts on financial aid
To learn more about the best rated 529 college savings plans, check out a recent article HERE.
2) Education Savings Account (ESA) or Education IRA
This account allows you to save up to $2,000 (after tax) per year, per child. And the great news is, it grows tax-free. You will likely earn a much higher return with an ESA than a traditional savings account. You also won’t have to pay taxes when you take the money out to pay for educational expenses.
The ESA comes with income restrictions. Income between $95,000 and $110,000 (single filers) or between $190,000 and $220,000 (married filing jointly). If you don’t meet the income requirements for an ESA and you would like the option to contribute more money per year, a 529 plan may be a better option.
The Pros
- Lots of investment options
- Grows tax-free
The Cons
- There are income restrictions
- Limited contributions of $2,000 per year
- The money can be accessed to the beneficiary by age 30, or they will be subject to taxes and penalties
3) Coverdell Education Savings Account (ESA)
The main difference between the Coverdell ESA and other college savings plans, is that it offers more flexibility as far as what qualifies as education expenses. The funds can be used to pay tuition for primary and secondary schools, along with costs for uniforms, tutoring and other K-12 expenses.
If your modified adjusted gross income is under $110,000 per year (or $220,000 per year for married-filing-jointly), then you would qualify for the Coverdell ESA.
The Pros
- More flexibility for qualified education expenses
- Less impact on financial aid, as it’s under the parents name
The Cons
- Contribution limit up to $2,000 per year
- Cannot contribute to the account once the child turns 18
- All funds must be withdrawn by the age of 30, or they will be subject to taxes and penalties
4) Prepaid Tuition Plans
This is another alternative to a traditional 529 savings account, specifically designed for children attending an in-state university. A prepaid tuition plan lets parents pay for tuition credits in advance and at a set price. With a 529 prepaid tuition “contract” plan, you are essentially paying for a certain number of semesters. With a “unit” prepaid tuition plan, you can buy units that are redeemable in the future, based on average tuition rates.
The Pros
- Prepaid tuition plans offer the same tax, financial aid and parental protections as 529 savings plans, but are not affected by stock market fluctuations.
- Avoid rising college tuition costs by prepaying
The Cons
- Limits a child from attending college out-of-state
- Funds only qualify for tuition costs, not other expenses (books, fees, computers, room and board)
- If the child no longer needs the funds, they will get a return on the money, but it will be federally taxed as ordinary income (repayment and state taxes vary by state).
- Plan holders may change beneficiaries at any time, however, a 10 percent penalty is applied
5) Educational Trust
A trust can be set up to hold assets for another person for a set time frame before allowing the funds to be accessed. Terms of the trust can be laid out during initial set up, indicating that the funds may only be used for expenses related to education or anything else you choose.
The Pros
- Gives the beneficiary more flexibility with how funds are used
- Easy transfer of assets to minimize estate taxes
The Cons
- Tax rules will vary depending on what kind of trust is created
- Possible taxes on income and trust fund earnings
6) Uniform Transfer/Gift to Minors Act (UTMA or UGMA)
These plans differ from ESAs and 529 Plans, because they are not just for the purpose of saving for education. The account is set up in the child’s name and is controlled by the custodian (typically a parent or guardian) until he or she turns 21. Once they reach the age of 21 (age 18 for UGMA), the account is then transferred to the child’s control to use at their discretion.
The Pros
- Money can be used for more than college education
- Tax advantages for the contributor
The Cons
- The beneficiary is free to use the funds however they choose once they reach legal age
- The beneficiary cannot be changed after setting up the account
7) Treasury Bonds
Investing in savings bonds may be a good option for some families, especially the risk averse. Because bonds are backed by the federal government, they’re extremely secure or low risk. When the money from the new Series EE Bonds and Series I Bonds is used for expenses related to education, the interest earned is tax-free.
The Pros
- Low risk
- Interest earned is tax-free
The Cons
- Low returns
- Not everyone qualifies for tax advantages, especially those with a high net worth
8) Real Estate Investing
Another strategy to build money for a child’s future education is real estate investing. While 529s and ESAs offer tax advantages, their return on investment can seem unimpressive. That’s one of the reasons parents may opt for multiple investments as part of their college savings plan, instead of just one.
Investing in real estate as a means to pay for a child’s college expenses without exposing yourself to too much risk can be approached with two strategies. The first strategy is the “Earmarked Asset” and the second is “Cash Flow as You Go”.
(1) The Earmarked Asset strategy basically means you can buy a rental property that is “earmarked” or designated for your child’s college fund. Over time, you pay off the mortgage with rental income and then sell the property when your child is ready to attend college. Using the money earned from the rental property for education expenses.
(2) The Cash Flow as You Go strategy allows you to consider tuition costs as an annual expense during the year it’s due. The idea is to have a plan in place to create a long-term real estate investment portfolio. So by the time your child is on her way to college, you will have enough passive monthly income through your long-term investments. You then fund the education expenses from your income statement.
Please note: this strategy should only be used if you plan to grow a large real estate portfolio that will create enough income to cover expected expenses.
The Pros
- Higher return on investment potential
- Investment portfolio diversification
- Create passive income for education and retirement goals
The Cons
- Subject to market fluctuations
- Higher risk if investment property is not kept long-term
- Not a liquid asset
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The Bottom Line
Now that you know your options for the best college savings plans, pick the strategy that benefits your family the most. Consider diversifying your portfolio by participating in multiple investments. One of the most valuable gifts you can give to your children is the opportunity to go to college and hopefully, graduate with no student loan debt.
