Where are you stashing your savings for your child’s education?
According to Sallie Mae’s 2018 report “How America Saves for College”, 45% of families who are saving are doing so with a general bank account.
This is not an adequate vehicle to use to hold a child’s college education fund, but many young families don’t know or don’t understand what other, more appropriate, options are available.
Let’s look at why a regular savings account is not the place to put college savings, and what Millennials with growing families can do with their cash set aside for education instead.
Why Families Need to Look Beyond Standard Savings Accounts
First, you need to understand why standard savings accounts present a problem for families.
While it’s wonderful that you’re saving for a child’s future, using the average savings account makes your job that much more difficult.
That’s because these accounts usually have such low interest rates that your money can’t harness the power of compound interest to grow in value. You’ll only have what you were able to save on your own with no opportunity to let your money earn significant amounts of interest.
And that’s if you’re lucky. If you start saving in the year before your child is born, the money you initially put into savings might eventually lose value over the 18 to 19 years it takes for kids to grow up and move off to college. You can thank inflation for that.
According to CollegeSavings.org’s college cost calculator, inflation increases by 3% to 4% each year — while the cost of college has grown at a rate twice that, at 6% to 7% per year. That means that the average savings account’s interest rate, which is at a mere 0.08%, is not nearly enough to help you keep pace.
It’s hard enough to save what you need to pay for higher education for your kids on your own. Let your money help you by putting it in an account designed to make college savings easier for parents, like a 529 Plan or an Education IRA.
What is a 529 Plan?
A 529 plan is a special type of savings plan that was designed to encourage parents to save for their children’s future higher education costs. They’re also known as qualified tuition plans and are sponsored by state agencies or university institutions.
There are two kinds of 529 plans, prepaid tuition plans and college savings plans. And they’re more than just a savings account, because the money you contribute can be invested . This provides a way for your money to earn a return and the account’s value to grow exponentially over time thanks to compound interest.
The two types of 529 plans are the prepaid tuition plan and the college savings plan. Both plans will help your money do more for you than it could in a standard savings account, but the prepaid plans come with less options than the college savings plans. With prepaid plans, parents don’t get to decide how the money is invested — and that’s a decision many families want to make for themselves.
Here’s how a 529 plan can help you save more for college:
- It’s tax-advantaged, meaning you pay no federal taxes on what the account earns.
- Depending on the state you live in, there may be additional state tax benefits.
- Only parents can access and control the account…
- …but anyone can contribute to it, making it easier for other loved ones to help save.
- There are no income restrictions that limit who can open a 529 plan.
It’s important for parents to understand that the money in a 529 plan can only be used for college or university expenses. But if your child doesn’t go to college, the account can be transferred to a sibling, or a cousin for their use.
What is an Education IRA?
Although education IRAs have been around for a little while, they’re not as well known as the 529 plan. They’re now known as Coverdell Education Savings accounts, and the American Taxpayer Relief Act that was signed into law in 2013 made some upgrades and changes to the rules surrounding these savings tools.
Technically, they’re not IRAs — but they work like those accounts.
Coverdell Education Savings accounts (or Coverdell ESAs) offer a flexible way for families to put away tax-free savings for not only college expenses, but also those associated with schooling in grades K through 12.
You can open an account for each child in your family, and you can max out your contributions at $2,000 per year.
How to Choose the Right College Savings Vehicle for Your Family
Both a 529 plan and an education IRA will make your task of saving for future college tuitions and expenses a little easier. Both are better options than letting your hard-earned money sit in a standard savings account, earning no return and no interest.
Many families opt for a 529 plan because the parents have control over the funds in the account. Coverdell ESAs are custodial accounts, which means assets in the account become the property of the account beneficiary — your child — when they turn 18.
The contributions limits on 529 plans are also much higher than Coverdell ESAs, which means families can put even more away into their college savings vehicle. And Coverdells have income caps, as well, which means high-earning families simply can’t use these accounts.
But that’s not to say Coverdell ESAs are no good. They have their advantages, too: families can invest anywhere in the market, where investments in the 529 plan are limited to what the plan sponsor offers; the account beneficiary (meaning the kids) can contribute to Coverdell ESAs on their own, even if their parents are over the income limit; and funds in the account can be withdrawn to cover eligible expenses for both primary and secondary education.
You don’t necessarily have to choose, either. Some families use both accounts.
The important thing, if you’re a young parent, is to do something. Yes, starting to save for your child’s education is a wonderful start.
Don’t be in the 45% of Americans saving for college via a standard savings account. The interest you gain won’t be able to keep up with inflation and you won’t maximize your money’s potential. Determine how much you need to save and put that money in the account that best meets your needs and allows your money to grow tax-free.
By Kali Hawlk, Staff Writer