How to Invest in College: Savings Plans and Options

The rising cost of higher education makes proactive financial planning essential for many families. Investing early and consistently can significantly ease future college costs, allowing funds to grow and potentially reducing the need for substantial loans. Various investment strategies can help families build a robust college fund, providing greater financial flexibility for educational goals.

Understanding 529 Plans

A 529 plan is a state-sponsored, tax-advantaged investment vehicle designed to encourage saving for future education costs. These plans offer federal tax benefits, and many states provide additional tax advantages, such as deductions for contributions. Earnings within a 529 plan grow tax-deferred, and qualified withdrawals are entirely tax-free.

Contributions to a 529 plan are made with after-tax dollars, so there is no upfront federal tax deduction. However, investment growth compounds tax-deferred, and qualified withdrawals are tax-free at the federal level.

Qualified education expenses are broad and include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. Room and board expenses also qualify if the student is enrolled at least half-time. Additionally, up to $10,000 annually can be used for K-12 tuition expenses.

Recent legislative changes have expanded the scope of qualified expenses to include costs associated with apprenticeship programs registered with the Department of Labor. Furthermore, up to $10,000 in student loan repayments per beneficiary can be made from a 529 plan. This flexibility makes 529 plans adaptable to various educational paths.

Account ownership typically remains with the contributor, who designates a beneficiary. The beneficiary can be changed to another eligible family member without tax penalty if circumstances change, allowing funds to be repurposed if the original beneficiary does not pursue higher education or receives a scholarship.

While there are no federal contribution limits, contributions are subject to gift tax rules. Individuals can contribute up to the annual gift tax exclusion amount, which is $18,000 per person in 2024, without incurring gift tax. Account owners can also “front-load” a 529 plan by contributing up to five years’ worth of gifts at once, totaling $90,000 in 2024, without gift tax implications, provided no other gifts are made to that beneficiary during the five-year period.

For financial aid purposes, 529 plans are generally considered an asset of the account owner, typically a parent, rather than the student. This classification is advantageous because parental assets are assessed at a lower rate (a maximum of 5.64%) in the financial aid calculation formula compared to student-owned assets, which can be assessed at up to 20%. This favorable treatment means 529 plans have a relatively low impact on financial aid eligibility.

Exploring Coverdell ESAs

A Coverdell Education Savings Account (ESA) is a tax-advantaged trust or custodial account for education expenses. Contributions are made with after-tax dollars, grow tax-deferred, and qualified withdrawals are tax-free.

One primary distinction of Coverdell ESAs is their annual contribution limit, which is capped at $2,000 per beneficiary per year across all accounts. This limit is significantly lower than the effective contribution capacity of 529 plans. Additionally, there are income limitations for contributors; higher-income individuals may be phased out or entirely ineligible to contribute.

Coverdell ESAs offer a broader definition of qualified education expenses compared to 529 plans, extending beyond higher education. Funds can be used for qualified elementary and secondary school expenses, including tuition, fees, books, supplies, equipment, academic tutoring, and even uniforms and transportation costs. This makes them versatile for K-12 educational needs.

Another notable feature is the greater investment control afforded to the account owner. Unlike 529 plans, which typically offer a limited selection of pre-set investment portfolios, Coverdell ESA owners generally have more freedom to direct investments within the account. This allows for a more personalized investment strategy.

Funds in a Coverdell ESA must generally be used by the time the beneficiary reaches age 30, with exceptions for special needs. Remaining funds not used for qualified expenses are subject to income tax and a 10% penalty. For financial aid, a Coverdell ESA is typically considered an asset of the student (if owned by the student) or parent, impacting aid eligibility more significantly than a 529 plan if student-owned.

Utilizing Other Investment Vehicles

Beyond dedicated education savings plans, other investment vehicles can fund college costs. These options offer varying flexibility and control, though not specifically designed for education. Understanding their features helps in selecting the most suitable approach.

Roth IRAs

Roth IRAs are retirement savings accounts offering tax-free withdrawals after age 59½, provided the account has been open for five years. Contributions are made with after-tax dollars.

A unique flexibility of Roth IRAs is that contributions, but not earnings, can be withdrawn at any time, tax-free and penalty-free.

Both contributions and earnings can be withdrawn tax-free and penalty-free for qualified higher education expenses, even if the account holder is under age 59½, provided the account has been open for five years. This makes a Roth IRA a flexible option for college funding. However, using these funds for college reduces the amount available for retirement. Contribution limits apply ($7,000 in 2024 for those under 50), and income limitations determine eligibility.

UGMA/UTMA Accounts

Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts are custodial accounts where assets are irrevocably transferred to a minor. A custodian manages the account until the minor reaches the age of majority, which varies by state, typically between 18 and 21. At that point, the minor gains full control over the funds.

Earnings within UGMA/UTMA accounts are taxed at the child’s tax rate, though they may be subject to the “kiddie tax” rules. The kiddie tax generally applies to unearned income above a certain threshold (e.g., $2,500 in 2024) and taxes it at the parent’s marginal tax rate, reducing the tax efficiency for significant earnings. For financial aid purposes, UGMA/UTMA accounts are considered assets of the student, which can significantly reduce eligibility for need-based financial aid due to their higher assessment rate.

The primary drawback of these accounts for college savings is the lack of control once the child reaches the age of majority. Funds can be used for any purpose, not just education, which may not align with the contributor’s intent. This, combined with unfavorable financial aid treatment, makes them less desirable than dedicated education savings plans.

Taxable Brokerage Accounts

General taxable brokerage accounts offer maximum flexibility without specific restrictions on how funds are used or contribution limits. These accounts are not designed with special tax advantages for education, meaning investment gains, dividends, and interest are taxed annually at ordinary income or capital gains rates. This can lead to less efficient growth compared to tax-advantaged accounts.

Funds in a taxable brokerage account can be used for any purpose, including college expenses, without penalties for non-educational withdrawals. This flexibility is an advantage if educational plans change or funds are needed for other goals. For financial aid, these accounts are considered assets of the account owner (parent or student) and are assessed accordingly.

The tax implications mean that a portion of the investment returns is lost to taxes each year, which can slow the growth of the college fund. Despite this, their unrestricted nature makes them a viable option for those who prioritize flexibility over tax benefits or who have already maximized contributions to other college savings vehicles.