The Best College Savings Plans: How to Save For College Right

Until you buy a house, college will probably be the most expensive thing you've ever paid for.  And for some of us, it might even cost more than the house.  So it's not surprising that you need the BEST college savings plan to help you avoid those pesky loans.

Education is expensive.  Especially in America.  So if you are looking to go to college someday or to put your kids through college, you know you have to save big time.

Luckily, there are some good options out there as far as college savings plans go.  Some offer great flexibility and tax benefits while others give your less risk and guaranteed returns.

In deciding which is best for you, be sure to keep in mind your financial situation now and your future finance goals.  The best college savings plan is the one that gets you to where you want to be financially.

So, without further ado, let's take a look at each of these options below.  And find out which is the BEST one for you.

Coverdell Education Savings Account

The Coverdell Education Savings Account (ESA), previously called the education IRA, is one of the most talked about college savings plan there is.  

With these college savings plans, the money you invest is allowed to grow tax-free.  And it will also be tax-free when you withdraw it for qualified education expenses.

In addition to colleges being covered by this savings account, you can also use your ESA to cover certain K-12 expenses.

One beneficiary can have more than one Coverdell ESA.  But the accounts must be set up before the beneficiary turns 18 (unless they are special needs).  And the maximum amount that can be contributed to any one person is $2,000 a year.

There are income limitations with these types of accounts though.  And if you make too much, you won't be allowed to open one.  

But the good news is you can have an ESA and a 529 college savings plan which could complement each other very well.

How it Works

You can open up a Coverdell ESA through a brokerage or other financial institution.  Once opened, anyone can make a contribution to the account up to the maximum of $2,000. 

Of course, the beneficiary must be under 18 for you to make contributions. Contributions, sadly, are not deductible and must be made in cash.

But, the more money you make, the less you can contribute to this type of account until finally you can't contribute at all.

If you are single making less than $95,000 (or married filing jointly $190,000), you can contribute the full amount.  But from that amount up to $110,000 for singles and $220,000 for joint filers, the amount you can contribute phases out.

And if you make more than $110k for singles and $220k for joint filers, you can't contribute at all.  

Eligible Educational Expenses

Qualified educational expenses are the expenses necessary to enroll and attend an eligible primary, secondary, or post-secondary school.  

Check out the list of qualified expenses below.

Things to Note:

One thing to note about having an ESA is that when the beneficiary turns 30, they must distribute the funds in their account.  But, if the beneficiary doesn't use it for educational expenses, it will trigger a 10% penalty and they will be taxed.

As an alternative, you could transfer the account to another member of the family who is under 30 from siblings to in-laws.  You can change the beneficiary of an ESA once per year.

Also, you can make contributions for the previous year up until the tax day of the following year.  

And another thing, if you go over the contribution limit in any given year, you will have to pay a 6% excise tax on the excess.  However, if distributions from the account that year equal the excess, you won't have to pay the excise tax.

Another way to get out of the excise tax is to deduct the excess amount from next year's contributions.  So if you went over by $500, then next year set the max contribution to $1,500 instead of $2000.  That way you won't have to pay the tax. 

The Advantages of the Coverdell Savings Account

The Coverdell education savings account has some good perks should you decide to open one up for your child's college savings plan.  

For starters, it is one of the few college savings plans that can be used not only for college but also for K - 12 expenses.  And these include a wide range of eligible expenses which is another perk.

Also, with a Coverdell ESA you have more investment options than some of the other savings plans.  And because this account is in the parent's name it has minimal affect on the financial aid received by the student.

Furthermore, even though there is a limit on how much you can contribute to one beneficiary, it turns out that corporations or trusts may make contributions to ESAs without income restriction limits.  

Talk about a good loophole!

The Pros

The Disadvantages of Coverdell Savings Account

For all the good of the Coverdell savings accounts, there are quite a few disadvantages.  One of the biggest ones being that not everyone can actually open up and contribute to it because of the income limits.

The yearly contribution limits are quite low so you might not be able to save as much as you'd like.  Plus, those contributions aren't deductible and must be made in cash.  

And in this digital age, having to always do cash might become a bit of a pain.

Furthermore, the accounts have very strict rules and penalties for excess contributions, contributing after the student has turned 18, and money still in the account when the student turns 30.

If the student turns 30 and there is money still in account, it must be withdrawn within 30 days or there is a 10% penalty and the remaining amount will be taxed.  

So you'd better move that money with the quickness!

In addition, if the account is owned by a grandparent or other relative, withdrawals count towards student's income.  This can have a big effect on the student's financial aid package.

The Cons

Need help staying organized? Check out this digital College Financial Planner!  Keep track of all your expenses, savings, grants, scholarships and more! 

Savings Bonds EE and I

If you are a bit on the risk-adverse side of things and don't want to invest your hard earned money into the stock market, you could invest instead in bonds as your college savings plan.  

Bonds are offered by the Treasury and are much less risky than stocks.  Not to mention, they are backed by the government.

So if you want a safe, guaranteed, and predictable return on your investment, then going the bond route may be for you.

However, even when you use them for qualified educational expenses, you may have to pay taxes on the interests earned from these bonds.

How It Works

First, to purchase one of these bonds you must be 24 years or older.  You can purchase the bonds online electronically.  And you. may use your federal tax refund to purchase them.

You can use these savings bonds for your or your children's educational expenses.  Although, you won't be able to use it if those expenses are already covered through financial aid, ESA, or a 529 college savings plan.

Once purchased, you can redeem them whenever you want.  But, be aware that if you hold them for less than 5 years there is a 3 month interest penalty.

Within the year that you redeem your savings bond, you must use it for a qualified education expense such as tuition.  By doing so, you won't have to pay taxes on the interest earned so long as the other conditions are met.

There are two types of bonds that you can choose from when it comes to saving for college expenses:  Series EE and Series I.

Savings Bond EE

The Series EE bond comes with a fixed interest rate and a guarantee by the US government that the bond will double in twenty years.  And if it doesn't, the government agrees to pay the difference.  They typically reach maturity after 30 years.

The smallest savings bond you can buy is $25 and the. most you can buy is $10,000 in a given year.

Series I Bond

Like the Series EE bond, the I bond comes with a 30 year maturity date.  They have a fixed and a variable interest rate to keep up with inflation.  That way, your returns will always be greater than inflation. 

But, sadly, unlike the Series EE bond there is no 20 year guarantee that your money will double.  And series I bonds cannot be bought or sold in secondary markets.

If redeemed early, like Series EE, there is a 3 month interest penalty.

Qualifying for Tax-Free Interest

In order to qualify and. not pay taxes on the interest you earn from these bonds there are certain rules that must be met.

• Funds must be used to pay for you, your spouse, or your dependent's qualified educational expenses
• Your income must be less than $97,350 (if you are single) and $153,550 (if you are married filing jointly)
• You are not married and filing separately

If you are single, your tax benefits start to phase out between $82,350 and  $97,350.  And if you are married filing jointly, they phase out between $123,550 and $153,550. 

Here's What Counts as Qualified Expenses

• Tuition and Fees
• Contributions to a Qualified Tuition Program (QTP), or 529 college savings plan
• Transferring funds to a Coverdell ESA

Expenses such as room and board and things for extra-curricular classes are NOT included.

Furthermore, if you receive tax-free grants, scholarships, distributions from your ESA or QTP, money from your employer, etc., they will reduce the amount of your qualified expenses.  

Even taking the educational tax credits such as the American Opportunity or Lifelong Learning Credit will reduce those eligible expenses.

Determining How Much is Tax Free

All of the interests earned from your savings bonds may not be tax free.  That's because the money you receive may be more than your qualified expenses.

If the money redeemed from your bond, is less than the amount of your qualified expenses, than it will be completely tax-free (so long as you meet the income requirements).  

However, if the redeemed amount is greater than your expenses, part of the interest might be taxable.

To calculate how much is tax free, you take your interest and multiply that by your adjusted qualified expenses (which takes into account grants, scholarships, et.) divided by the total redemption amount of your bond.

Example

For example, you redeem your savings bond to pay for your daughter's tuition ($10,000).  The total amount of your bond is $10,000 with $5,000 being interest.  Your daughter also got a $2,000 grant to help pay for her tuition.

So, you would subtract the $2,000 grant from her qualified educational expense of $10,000 (=$8,000).  Then using the equation ($5,000 x [$8,000/$10,000]), you find that $4,000 of your interest is tax free.

Therefore, you would only have to pay taxes on $1,000 of interest.  But wait.  You might be able to exclude a bit more depending on your income.

How Your Income Can Affect Your Tax-Free Interest

If you are single and make less than $82,350, all of your interest would be tax-free ($123,550 if married filing jointly).  But, as your income increases up to $97,350 for singles and $153,550 for married filing jointly, your exclusion benefits decrease until it equals $0.

So if your falls between $82,350 and $97,350 and you are single, then part of your interest will be tax free.  

To figure out how much, you will first need to subtract $82,350 from your income ($123,550 for joint filers).  Then divide by $15,000 ($30,000 for joint).  

This will give you a fraction.  Take this number and multiply it by the number you calculated above for the taxable amount of your interest ($1,000).

So if you made $87,350, then you would subtract $82,350 which equals $5,000.  Then divide it by $15,000 which equals 0.333.  And finally, you'd multiply that by your $1,000 which equals $333. 

Subtract $333 from $1,000 and you get $667.  This means that $667 of that $1,000 is excludable.  So you would pay taxes on only $333 of your interest.

To claim this exclusion, use Form 8815. (pdf)  This form will also walk you through the steps of calculating how much of your interest is tax free.

Advantages of Savings Bonds for College

One of the main benefits of using savings bonds to save for college is that they are one of the safest investments and the only one backed by the US government.

They provide pretty good tax benefits as there are no state or local taxes on the interest.  And no federal taxes on interest as long as it's used for educational purposes and you meet all the other conditions.

Furthermore, they provide a low-risk, safe return on investment for parents who may not want to invest in riskier assets.  And they provide a way for you to diversify your assets.

In addition to that, you don't need a broker to purchase these savings bonds so you can save yourself some pretty hefty broker's fees.  

Plus, there is a low minimum investment amount necessary to buy so even low income families can take advantage of this opportunity.

And, unlike some of the other college savings plans, savings bonds are the parent's asset so it has less impact on the student's financial aid.

The Pros

Disadvantages of Savings Bonds for College

There are a few disadvantages to using savings bonds as your college savings plan.  For one, there are income limits for receiving the tax benefits of the bonds so not everyone is able to take advantage of the benefits they offer.

Also, you are limited in terms of what you can actually use the money for.  All educational expenses are not qualified and that can put a real kink in your savings plans.

Plus, of all the college savings plans, your returns on this investment will probably be the lowest.  Not to mention, there are early withdrawal fees if you redeem it in less than 5 years.

The Cons

Custodial Accounts

If you want to save money for your child's future whether it be for education or just a coming of age gift, you could open up a custodial account.

A custodial account is an account that is managed by an adult for a minor.  These accounts are often held at a brokerage or bank and its funds can be invested in various assets such as stocks, bonds, and mutual funds.

Anyone can make contributions to them.  But if you don't want to incur a gift tax, you should keep it below $15,000 if you are single and below $30,000 if you are married and file jointly.

How It Works

The custodian of the account, the adult, decides when and which securities (i.e. stocks, bonds, etc.)  to buy and sell.  They also make decisions such as whether to take out money from the account or not.

If they do take out money from the account, it must be used for the minor's benefit.  Then once the minor comes of age, the account is transferred to them irrevocably.

In some states, you may be able to choose when (at what age) the account will be transferred so be sure to check the fine print and choose wisely.

These accounts have been around for a while now.  And many people use it as part of their college savings plans.  

There are two types of custodial accounts: The Uniform Gift to Minors Act (UGMA) and The Uniform Transfers to Minors Act (UTMA).

UTMA Accounts

With a UTMA, you can invest in just about any asset including real estate, art work, and intellectual property.  And that is in addition to the usual stocks, bonds, mutual funds, etc.

You can open this kind of custodial account in all states except South Carolina.

UGMA Accounts

Unlike the UTMA, with the UGMA you can only invest in stocks, bonds, mutual funds, insurance, and annuities.  But that might not be a big deal if you were only planning on investing in these kinds of assets anyway.

Also, unlike the UTMA, this savings account is available in all states.

Depending on the institution, there may be a required initial deposit or specific account minimums.  So be sure to look around and compare.  And don't forget to check the interest rates and fees (if any)!

The Benefits of the Custodial Accounts

These custodial accounts do come with some perks that some of the other college savings plans do not.  Namely, flexibility.

First off, with these custodial accounts there are no withdrawal penalties and no income or contribution limits.  You can literally make as much as you want and contribute as much as you want to the accounts.

What's more, these savings accounts do not have required distributions like some other accounts do.  So you could essentially have this account for life (if you are the beneficiary).  And if you die, it simply becomes a part of your estate.

They also provide a cheaper and easier solution than setting up a trust fund for people who would like to leave something for their children.

Another advantage of these accounts are the tax benefits.  In 2020, the first $1,100 earned from investments in the account were tax free.  Then the next $1,100 was taxed at the lowest rate, 10%. 

Anything more than that would be taxed at the parent's normal rate.

The Pros

The Cons of the Custodial Accounts

While there are quite a few perks to having a custodial accounts, there is a downside.  A big one.  Especially when it comes to using these accounts to save for your children's education.

With custodial accounts once the minor becomes of age, it is automatically transferred to his or her name.  In doing so, when it comes time to apply for financial aid, the colleges see the money in the custodial account as income for the student.

This could greatly reduce the amount of money your child can receive for financial aid.  It might also prevent them from applying for other grants and scholarships as many are need-based.

This might be the exact opposite of what you were going for when you thought you'd prepare for your child's educational future.

Another downside is the beneficiary cannot be changed.  Once it's set, that's it.  

The Cons

529 College Savings Plans

Qualified Tuition Programs (QTP), often called 529 college savings plans, are a popular way to save for your child's future college expenses.  And with recent changes to the rules, you can now use it to pay for K-12 grade expenses.

Unlike the others, these college savings plans are sponsored by the state or educational institution.  The offer tax advantages but these advantages may vary depending on the state.  Some states even offer tax deductions for your contributions.

The money you put in these accounts are allowed to grow tax-free and when you use it for educational purposes, they are tax-free upon withdrawal as well.  Of course, if you withdraw it for other purposes, there is a 10% penalty and you will have to pay taxes.

There are two different kinds of 529 college savings plans that you can choose from:  Prepaid tuition plans and education savings plans.  And you can open up these accounts at most brokerages or other financial institutions.

Prepaid Tuition Plans

With these college savings plans, you can pre-pay for the tuition (or credits) for the college of your choice.  The benefit being that you will lock in a cheaper rate for tuition than it would be in the future.

But, this plan might be a little restrictive for most, as it can only be used to cover tuition and not books, room & board, etc.  And it cannot be used for K - 12 expenses.

Also, if your child decides not to go to a school covered by this plan, you may end up not saving any money whatsoever.

Education Savings Plan

The education savings plan is very different from the prepaid tuition plan.  With this plan, you have the ability to invest your money and allow it to grow tax-free in the account.

Furthermore, withdrawals from this plan can be used for room & board, tuition, textbooks, and K-12 education expenses.  However, for K-12 expenses you can only use up to $10,000 of your 529 savings plan per year.

With recent changes, you can now use these funds to pay for apprenticeship programs.  What's more, you can even use up to $10,000 to pay on your student loans.

The Advantages of 529 College Savings Plans

There are many advantages of using a 529 college savings plan to save for your loved ones future.  A big plus being that there is no limit to the amount you can contribute.  

Even though there is no limit, you must be careful not to trigger the gift tax.  This happens when you give more than $15,000 if you are single (or $30,000 if you are married filing jointly).  You can opt to make a lump sum payment. But if you do so, you must skip the next however many years of contribution.

Another huge benefit is that there are no income restrictions so anyone can start one.  

Plus, you can use the educational savings plan to pay K-12 expenses, pay for apprenticeship programs, and pay back up to $10k in student loans.

The Pros

The Disadvantages of 529 College Savings Plans

There are a few disadvantages to 529 savings plans.  For starters, these accounts may be subject to yearly fees just to keep them open. 

Plus, since you are investing your money in the stock market, this plan does come with its risks.  You could potentially lose the money you invest. 

Also, unlike the Coverdell ESA, the amount of money you can use on your child's K-12 expenses is limited to $10k per year.

The Cons

Roth IRA

While this is not an official college savings plan, it can be used that way.  That is because when you withdraw money from this account and use it for educational expenses, you can avoid that 10% early withdrawal penalty (for people under 59 and a half).

What's more, because you are taking money from your Roth IRA, withdrawals of your contributions are tax-free and penalty free when used for educational expenses.  

However, withdrawals of earned interest, while penalty free for educational purposes, are not tax-free.  So you'd have to pay taxes on that portion if you are not of retirement age.

What about the other IRAs?

This is not the case for traditional or SIMPLE IRAs.  While you can use these accounts for educational expenses, you will still have to pay taxes on the distributions.

Plus, if you withdraw your contributions, you will have to pay the 10% penalty tax if the amount is higher than the adjusted qualified educational expenses (or the amount after you deduct other tax-free benefits such as scholarships, grants, employer assistance, or savings from ESA plans, etc).

Who Can Use It? and How?

The great thing about using your IRA or Roth IRA to pay for educational expenses is that you can use it for more of your family members.  These include: you, your spouse, your children (fostered and adopted included), your spouse's children, and you or your spouse's grandchildren.

Furthermore, you can use the money you withdraw for more expenses than some of the college savings plans listed above.

Here's what you can spend it on:

The Pros and Cons

As with all the others there are some plusses and minuses when it comes to using your IRA/Roth IRA for you or your loved ones educational expenses.  Let's take a quick look at them below.

The Pros

The Cons

All in All

I'm not a financial advisor and more specifically, I'm not your financial advisor.  So while I have my opinion on which college savings plan is the best, it is up to you to determine which is for you.

Don't forget to take into account your future financial situation.  

If you think you will be making more money in the future, then you might want to rule out savings bonds or any of the other college savings plans that have income limitations on them.

And if you think your child will be able to get merit or need-based scholarships and grants, you may not want to have a custodial account in their name messing with their chances of getting them.