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4 Ways to Save for Your Child’s College Education
- 529 Plan – best overall
- Coverdell Education Savings Account (ESA) – best for private K-12 expenses
- Individual Retirement Account (IRA) – best for dual-purpose college and retirement saving
- Brokerage Account – best for overall flexibility
- 529 Plan
The 529 savings plan is our recommended college savings method for most people. The name of this account comes from the section of the Internal Revenue Service (IRS) code that defines it. This type of college savings account is managed at the state level. You can choose any state’s 529 plan based on the included benefits, which can vary significantly. This account is our favorite for saving for your child’s college education since it is tax-advantaged, with no distribution age limits for most states, no income limits, and the only contribution limit is federal gift tax on gifts greater than $17,000 (in 2023).
The 529 savings account is created for a beneficiary, which can be a child or grandchild, and the account can be transferred to one of the beneficiary’s siblings at any time in the future. This account is funded with post-tax money and comes with tax-free growth and withdrawals for qualified expenses, including tuition, books, private K-12 tuition, apprenticeships, and repayment of student loans. If money is withdrawn for non-qualifying expenses, it is subject to both taxes and a 10% penalty, so it is important to only contribute money that you are confident will go toward educational expenses.
- Coverdell Education Savings Account (ESA)
The Coverdell ESA is another popular way to save for your child’s college education. This account was named after the congressman who championed its legislation. The ESA is very similar to the 529 account, but with a few key differences.
This account is also a tax-advantaged account, but has an age limit of 18 years old for contribution and 30 years old for distribution. ESAs also have income limits of $110,000 for filing single and $222,000 for married filing jointly, along with a contribution limit of $2,000 per child per year. Also just like a 529 account, an ESA is funded with post-tax money and comes with tax-free growth and withdrawals on qualifying expenses. The same tax requirements and 10% penalty apply to non-qualifying expenses.
The ESA has two main advantages over the 529. One of the advantages is having many more investment options, and the other is more qualifying expenses for private K-12 education, including supplies, room and board, transportation, and tutoring. The ESA is a great college savings account, but is more restrictive than the 529, unless investment control and private K-12 expenses are your top priorities.
- Individual Retirement Account (IRA)
The next best type of college savings account is an individual retirement account (IRA). There are two different types of IRAs to consider, which are the traditional IRA and Roth IRA. These accounts are similar in that both provide tax-free investment growth, unlike brokerage accounts. These accounts also let you contribute the same amount on an annual basis, which is $6,500 for under 50 years old and $7,500 for over 50 years old. Traditional and Roth IRAs also have the same age limit of of 59 ½ for premarital-free withdrawals.
One key differences between these accounts is that a traditional IRA is funded with pre-tax money while a Roth IRA is funded with post-tax money. If you expect to be in a higher tax bracket in retirement then a Roth IRA may be preferred since it would allow you to avoid taxes on your distributions. The Roth IRA also doesn’t have required minimum distribution (RMD), unlike the traditional IRA, which requires RMDs starting at age 72. The main reason a traditional IRA may need to be chosen over a Roth IRA is the income limit to contribute to a Roth IRA. The Roth IRA income limits in 2023 for single, head of household, or married filing separately are under $138,000 for full contribution and under $153,000 for a limited contribution. Roth IRA income limits in 2023 for married filing together are under $218,000 for full contribution and under $228,000 for a limited contribution. Traditional IRAs do not have a contribution income limit.
While IRAs weren’t specifically designed for college expenses, there are a couple key reasons why it might be the best option for you. One reason is that you can make penalty-free withdrawals for qualified higher education expenses. Another reason is that these accounts give you the flexibility to save for both college education and retirement at the same time. Just be sure to consider the that using a retirement account for college savings will have on your retirement plan since you will be sharing your annual contribution limit for two purposes, which will take away from your retirement saving potential.
- Brokerage Account
A brokerage account is an after-tax investment account that is not tax-advantaged. This means that investment gains and dividends are subject to long-term capital gains tax. If the account is guaranteed to be used for educational expenses, then all the tax- advantages accounts discussed above will be preferred over this account.
The main advantage of a brokerage account is that you can do whatever you want with this money without worrying about additional penalties. If a lot of the money will also be used for non-education expenses that could result in penalties for a 529, ESA, or IRA, then you may want to consider using a brokerage account instead. We don’t recommend brokerage accounts as primary college or retirement savings vessels, but we do still think they can play a role in saving for these major expenses, along with providing a much higher return than your savings and checking accounts. There are no contribution limits for brokerage accounts, so extra money available after maxing out other tax-advantaged accounts could be added to a brokerage account for additional investment gains.