7 Effective Ways to Save for College Today

Saving for college is a major financial goal for many American households. In fact, three out of five American parents actively set money aside for their children’s educational goals. Those parents have an average savings goal of $55,342 per child.

Although a majority of Americans are preparing for higher education expenses, the results are split on the best way to save for college. Some parents make deposits into a college fund, and others reduce household and personal spending or take on more hours at work.

If you’re unsure about how to save for college, here are seven of the best methods available for parents today.

1. Open a 529 plan

A 529 plan is a tax-advantaged investment vehicle. Deposited funds can be withdrawn tax-free to pay for qualified educational expenses for post-secondary tuition, K-12 education or apprenticeship programs.

Two types of 529 plans are available:

1. A prepaid tuition plan that lets the account holder purchase units at a qualifying school.
2. An educational savings plan that allows the account holder to use the funds at any college or university.

One of the benefits of a 529 plan is that you can directly deposit any financial gifts the child might receive from family and friends, which simplifies the saving process.

Before committing to a 529 plan, it’s important to know the drawbacks. For instance, if funds are withdrawn for non-educational expenses, you’ll pay a 10% federal tax penalty. Also, there are limited investment options for the funds — you might even earn a higher return with an alternative strategy.

There are multiple 529 plans you can choose from, so compare 529 plans online before getting started.

2. Invest in mutual funds

In contrast to 529 plans, saving for college using a mutual funds investment strategy is considerably open-ended. You can invest in any mutual funds you want and use your earnings for any purpose. Mutual funds are often seen as a way to gain some exposure to the market, while minimizing your risk through their diversification.

But, there are some caveats to using mutual funds when investing for college. Unlike the 529 plan, there are no tax savings associated with mutual funds. That means you’ll pay income taxes on your earnings each year, and you’ll owe capital gains taxes when you sell. These assets can also reduce financial aid eligibility.

If you want to get started with investing in mutual funds to save for college, you can do so by using a traditional financial advisor or stockbroker. You can also start by using online brokerages such as Betterment, or the online arms of traditional brokerages such as TD Ameritrade or Charles Schwab.

3. U.S. savings bonds

U.S. savings bonds are typically considered one of the most low-risk investments strategies available. Not only are they government-guaranteed, but they’re also free of state and local taxes.

You have to pay federal taxes on the earnings at maturity. However, the interest from Series EE and Series I bonds purchased after 1989 is usually free of federal tax if used for higher education expenses.

That said, there’s an income requirement to this tax advantage. The exclusion is limited if your income is $123,550 to $153,550 for married taxpayers filing jointly, and $82,350 to $97,350 for all other taxpayers.

If your adjusted gross income is equal or greater than the upper limit for your filing status, you won’t qualify for the interest exclusion.

To purchase bonds as investments for college savings, buy them directly from the U.S. government via Treasury Direct. Bonds can only be purchased in electronic form.

4. Roth IRA

Roth IRAs are typically used to save for retirement, but are tax-advantaged for higher education expenses, too. Contributions to a Roth IRA grow tax-free and you can withdraw them at any time without a penalty.

After the age of 59½ you can also withdraw your earnings from the Roth IRA tax and penalty free. If this time frame coincides with when your children are in college, this presents a savvy way to save for their education. If you don’t use all of the funds for higher education expenses, you can use the remainder toward your retirement.

The downside of using a Roth IRA for college expenses is the low annual contribution limit. In 2021, the limit is $6,000 (or $7,000 if you’re 50 years or older).

Also, there’s a chance you might earn too much to contribute the maximum as the Roth IRA imposes income limits. You’ll also have to report Roth IRA withdrawals for educational expenses on the FAFSA; this might affect your child’s financial aid award.

Setting up a Roth IRA is straightforward and can be done through a broker or robo-advisor.

5. UGMA/UTMA account

The Uniform Gift to Minors Act and the Uniform Transfers to Minors Act let you establish custodial accounts to save funds for your child’s higher education.

These funds are more flexible than 529 plans despite UGMA/UTMA accounts not having the same tax advantages. There is also no limit to how much you can invest, although these accounts are counted a student asset, which can impact federal aid eligibility.

You can open a custodial account through a traditional broker or an online stock broker.

6. Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (ESA) is a tax-advantaged trust account that’s designed to help parents save for educational expenses. Funds can be withdrawn tax-free if used for higher education or K-12 expenses.

One significant benefit to an ESA is that you have more authority to direct your funds than you would with a 529 plan. Plus, when it comes to federal aid eligibility, it isn’t counted as a student asset, rather it’s considered a parental asset. This means a smaller percentage funds in this account are counted when calculating federal financial aid awards.

However, there are some drawbacks to opening an ESA. To start, the maximum amount of contributions annually for any beneficiary is $2,000. In most cases, all contributions to the account must be made before the beneficiary turns 18 years old. Then, the beneficiary must  use the funds before turning 30 years old.

You can open an ESA to invest for college costs online or in-person through any major bank or broker.

7. Certificates of Deposit

Using a Certificate of Deposit (CD) to save for college offers flexibility and security. The low-risk nature of CDs are why some parent savers opt for this strategy for at least part of their financial plan.

Funds from a CD can be used for any purpose. For example, if your child decides not to go to college, you can put the money toward other pursuits. CDs are also very secure and have fixed returns, even though you have to wait for the term to mature.

One downside to CDs is that they typically don’t earn a large return. There’s also a chance that your CD might not outpace inflation. Even if your CD has a guaranteed 5% return, if the cost of goods inflates by 6%, the funds in your CD will actually have less purchasing power at maturity.

That said, there are many different CDs available with a variety of terms and maturities that can help you hedge against some of these negatives.

You can open a CD through many traditional or online banks and financial institutions. Be sure to compare CD rates online to get the best deal possible.

The Bottom Line

Chances are you’ll use more than one investment strategy to save for college. Combining strategies that take into account your risk tolerance and ultimate savings goals is the best way to save for college.

Keep in mind that when figuring out how much to save for college, you don’t have to save your child’s entire college education cost. Your child also has access to other forms of financial assistance, like grants, scholarships, and federal and private student loans to help fill the gap.