How to save for college - Student Loan Grace Period

How to Save for College: Complete Guide to Saving for Education

Saving for college is one of the most important financial goals for students, parents, and even grandparents. And for good reason.

  • In 2019-2020, the average cost for in-state tuition, fees, and room and board at public universities was $21,950, according to the College Board.
  • If you wanted to attend a private university, the average cost was $49,870.
  • The latest statistics from the Federal Reserve put student loan debt at $1.6 trillion.
  • It will take the average student 21.1 years to pay off her student debt.

If you’re thinking there has to be a better way, you’re completely right.

How to create a “save for college” strategy in  three steps

The good news is that there are excellent savings options available to parents and students that can help with educational expenses. Sadly, many don’t know about these saving options. For example, according to a recent Harris College Financial Preparedness survey, three out of four investors don’t have a basic understanding of how 529 college savings plans work. This guide will provide a clear and easy to understand blueprint to build your education savings strategy.

There are many questions to consider when saving for college and other education expenses. It can get overwhelming fast. That’s why it’s a good idea to focus on the three most important questions.

  • How much will it cost?
  • What savings vehicle is best for you?
  • What tax benefits are available?

By the time we answer these questions, you will know everything you need to know about saving for college. If you’re in a rush, here is the short version of our guide.

How to save for college

  1. Estimate the cost. College is expensive, so plan ahead. It probably will be much more expensive by the time your child goes to college. Historically, student costs have increased at double the rate of inflation.
  2. Choose the best savings vehicle for your family. It’s worth reading through the different options, but for most families, the best option is either a 529 Plan, a Coverdell ESA, or an IRA.
  3. Don’t forget to take into account tax credits and deductions. Remember, you can’t qualify for tax credits if you paid with money from a tax-free or tax-deferred account. So, if you are maxing out your tax-advantaged accounts, it may be a good idea to have some savings for education in a regular investment or custodial account.

Step 1: Estimate the cost of education

Calculating the amount of money you need for future education expenses is a challenge. There are too many unknowns to predict the cost accurately. However, it is possible to make useful and legitimate estimates on which to base realistic plans.

There are three steps to calculating the cost of higher education:

  • Choose the type of education (college, career school, apprenticeship, etc.)
  • Estimate the future cost by taking into account inflation and student cost trends.
  • Consider how to minimize the total cost (financial aid, scholarships, grants, etc.)

The cost of education will vary dramatically depending on the type of education you or your children are pursuing. At this stage, it’s worth considering the return on investment of the college or line of work you choose. Are you planning for an apprenticeship, technical school, or college? Will it be a community college, state, or private? Will your child live at home or on campus? Is law or medical school in the cards? Or are you planning to enroll in a coding boot camp? The options are endless, but for most people, calculating educational expenses means working out the cost of college.

College Type

Tuition & Fees

Room & Board

Total (1 year)

In-state public college$10,440$11,510$21,950
Private college$36,880$12,990$49,870

The table above shows the average cost of one year at state and private colleges now. However, the cost of education in 18 to 20 years may be very different. On average, the cost of tuition has increased by 6% a year. That is double the rate of inflation, which is approximately 3% a year.

If this trend continues, it will cost an average of $250K to $570K to send a child to a private college 18 years from now. Nobody knows if the rate at which education costs increases will hold, but it provides a useful benchmark to help you determine how much you may need to save.

College Type

Total cost (4 years) 2020

Estimated cost in 2038 (6% annual increase)

Estimated cost 2038 (3% inflation rate)

In-state public college$87,800$250,600$149,470
Private college$199,480$569,400$339,600

Once you know what your goal amount is, you can work out what your monthly savings need to be. This requires you to make some educated guesses about how much inflation will be, the rise of education costs, and how much interest you will earn until you need to access your savings.

How can you minimize the cost of education?

If you don’t have the time or resources to save the entire amount you need for college, financial aid is available. There are three types of financial aid to consider:

  • Grants and scholarships, which are awards or gifts that don’t need to be repaid.
  • Student loans, which do have to be repaid. However, the interest you pay on them may be tax-deductible.
  • Federal work-study programs, which require you to both prove a financial need and to work to receive assistance.

In order to qualify for financial aid, every student needs to complete the Free Application for Federal Student Aid (FAFSA). Financial aid guidelines and formulas change over time. So, it is hard to plan for 10, 15, or 18 years down the road. However, parents can maximize the financial aid their children will receive by putting as many college assets as possible in their name, and choosing asset distributions that are non-taxable. How do you that? A lot depends on the type of savings vehicle you choose. This is what you need to know.

Step 2: Choose the best savings vehicle for you

Now we have a rough idea of how much we need to save; it is time to find the savings vehicle that offers the best tax and financial aid benefits. There are three main features to consider when choosing a savings account for education expenses: tax benefits, control of assets, investment flexibility, and its impact on financial aid.

To help you choose, here is a summary of the educational savings options available. You will find a more detailed analysis of each option at the end of this guide.

The top 8 savings accounts for college

  • IRAs. Good for retirement and education expenses. IRAs provide tax advantages and have a low impact on financial aid. However, distributions from an IRA counts 50% toward the expected family contribution if owned by the student and 22% to 47% if owned by the parent.
  • 529 Plans. Flexible education savings plans that offer tax advantages and a high contribution limit ($200K or more).
  • 529 ABLE plans. A 529 plan for children with special needs. Provides generous tax advantages and the first $100K don’t count as personal assets for Medicaid or Social Security purposes.
  • Coverdell Education Savings Accounts (ESAs). Also known as Education IRAs, they offer excellent tax advantages but have more stringent usage restrictions and contribution limits.
  • Series EE Government Bonds. Education bonds are a risk-free investment (but very low returns) that also offers tax advantages. However, these tax advantages are phased out for higher-income families.
  • Custodial Accounts (UTMAs /UGMAs). Custodial accounts provide complete flexibility on how you invest and spend the money. However, they have a negative impact on financial aid and only modest tax benefits.
  • Private Investment Accounts. No limits on contributions and you have complete control on how you invest and spend the money. However, there are no tax advantages and it can limit access to financial aid.
  • Trust Accounts. A good option for wealthy families for their estate and tax planning benefits. They offer confidentiality and control over usage and investment options.

If you’re not sure which option is best for your family, talk with a financial planner. The taxation and financial aid implications of each option can get complicated if you’re not used to dealing with investment vehicles. However, you can do it all by yourself by opening an account with a brokerage or a robo-advisor.

Should I prioritize retirement or college savings?

For most families, it makes sense to first max out IRA contributions and then contribute as much as you can afford to a 529 plan or Coverdell savings account. However, don’t view your IRA as a piggy bank for your children’s education expenses. Although you can use your retirement savings to pay for college costs, it could mean you don’t have enough for retirement. Your first priority should be to save for your retirement and then toward your children’s education expenses. In that order.

Saving for college is very important, but ultimately it’s a luxury. Having enough money for basic living expenses when you retire is a necessity. An advantage of IRAs is you can use them toward education expenses without paying a penalty, but they don’t count as income for financial aid purposes. In a pinch, you can use your IRA savings to help with your children’s education, but they won’t reduce the financial aid for which they qualify.

How to coordinate your college savings with financial aid

Most students are eligible for financial aid when they go to career school or college. Of course, how much they receive depends on, among other things, their family’s assets and income. The wealthier a family is, the less financial aid they receive.

Nevertheless, not all assets have the same impact on financial aid calculations. Some accounts, such as retirement assets, annuities, home equity, and the cash value of a life insurance policy have no impact at all on student aid. In general, it is better for families to save for college using accounts that are considered an asset of the parents instead of the child.

The table below summarizes the impact of each savings account on financial aid.

Savings account

Counts as an asset

Counts as income

IRAs, cash value on life insurance plansNon/a
Annual pre-tax contributions to IRAs and 401(k)sNoYes
UGMA/UTMA with the student as the beneficiaryHigh impact (student’s asset)High impact (student’s income)
529 plans owned by parent or studentLow impact (parent’s asset)No
529 savings owned by a third party, such as a grandparentNoHigh impact (student’s income)
Education Savings Accounts (student is a dependant)Low impact (parent’s asset)No
Education Savings Accounts (owned by a third-party, such as grandparents)NoHigh impact (student’s income)

In whose name should I put the savings account?

An essential factor to consider when choosing a savings vehicle is who will own it. Why is this important? For financial aid purposes, assets in the name of the parent have a smaller impact on aid than assets in the name of the student. Around 20% of the assets in the name of the student count as money available for college. However, a maximum of 6% of the assets of parents (for some families less than 3%) are considered as money available for college.

Super tip. If you put 529 college savings plans in the name of a non-custodial relative or friend it doesn’t count as income for financial aid purposes. So, in some cases, it may be a good idea to keep educational savings in the name of your child’s grandparents or other relatives.

The pros and cons of the best education savings accounts

As mentioned above, IRAs, 529 plans, and education savings accounts, such as Coverdell savings accounts, are the way to go for most middle and low-income families. However, the best option for you may be different. Invest a few minutes to review the pros and cons of the six main education savings vehicles.

Private investments accounts

Traditional private investment accounts are probably the least tax-efficient alternative, but it certainly provides investment flexibility.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of private investment accounts.

Pros
  • Unlimited contributions. Unlike other options, there isn’t a cap on how much you can save.
  • Investment options. You get complete control over what you invest your savings in.
  • Control over the money. Most education savings vehicles have rules on when you can use or transfer assets.
Cons
  • No tax benefits. Other accounts offer tax-deferred growth and tax-free withdrawals.
  • Contribution limits. This is not an issue for most families, but contributions are capped at $15K a year per parent before triggering gift taxes.

If you do choose a private investment account for your educational savings, remember that assets in the child’s name will severely reduce the financial aid for which they will qualify.

Custodial accounts

Custodial accounts allow you to place assets in the name of minors and assign a custodian to manage the investments until the child is of age. They provide flexibility and some tax benefits, but you sacrifice flexibility and control over the assets.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of custodial accounts.

Pros
  • Parents can manage assets. Parents (or the custodian) can control the account until the child is 18 or 21.
  • Tax-deferred growth. Any income under $2,200 enjoys tax benefits. The first $1,100 is taxed at 0%, while the next $1,100 is taxed at a single taxpayer rate. Anything above $2,200 is taxed at the parent’s highest marginal rate.
  • Control over the money. Most education savings vehicles have rules on when you can use or transfer assets.
  • Distributions qualify for tax credits. Because disbursements from custodial accounts are not tax-free, the money in them typically qualifies for the American Opportunity Tax Credit and the Lifetime Learning Credit.
Cons
  • Parents lose control of their assets. Once the child is of age, parents no longer get to decide how the assets are used.
  • The money counts as the child’s assets. This will reduce the financial aid she will receive.
  • Can’t change the beneficiary. Unlike other accounts, parents can’t change the name of the account owner.
  • Estate tax implications. If the custodian and the donor are the same person, the IRS considers the money as part of her estate for tax purposes.

Coverdell Education Savings Accounts (ESAS)

The Coverdell Education Savings Account (ESA) is similar to a Roth IRA. It allows you to set aside up to $2,000 per year per child with the possibility of tax-free distribution of earnings if you use the money for education expenses.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of Coverdell Education Savings Accounts (ESAS)

Pros
  • Tax-deferred investment. You don’t have to pay taxes on the income and capital withdrawn from the account as long as you use it for education expenses.
  • Tax-free distributions. As long as you use the money for education expenses, there is no tax on distributions.
  • Control over the investments. As with IRAs, you get to choose how to invest the money in the account.
  • Low student aid impact. Even though the child is the legal owner, the assets are usually considered as the parent’s money.
Cons
  • Not available to high-income earners. If you make more than $95K a year ($190K for joint filers), participation is phased out.
  • Contribution limit. There is a maximum contribution of $2,000 per child every year.
  • Age limit. If there is a balance in the account when the beneficiary turns 30, the balance must be distributed within a month.
  • Estate tax implications. If the custodian and the donor are the same person, the IRS considers the money as part of her estate for tax purposes.

529 Plans

A 529 plan is a tax-advantaged savings plan for college that is included in Section 529 of the Internal Revenue Code. There are two main types of 529 plans: prepaid tuition plans and 529 savings plans.

Prepaid tuition plans allow you to buy credits (and sometimes room and board) in advance at participating colleges. These plans are sponsored by individual states and usually require you to meet residency requirements to qualify. They are designed to pay in-state public tuition and fees at the time the child goes to college. They don’t represent a fixed dollar amount. If the child were not to attend a pre-funded state college, you could use the funds toward a private or out-of-state school. However, the dollar amount of the savings plan would be based on the average cost of attending an in-state public university, not the actual costs of the out-of-state or private college.

529 savings plans allow you to save for college and other education expenses without paying taxes on the income generated by the account. They provide greater investment flexibility, but you still have to choose from predefined investment options set by the plan. You can use the money to pay for a variety of qualified education expenses, such as tuition, fees, room and board, and books.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of 529 savings plans

Pros
  • No income limits. Unlike Coverdell Education Savings Accounts, 529 Plans does not phase out high-income earners.
  • Tax-deferred earnings. As long as you use the money for education expenses, there is no tax on the income generated by the 529 Plan.
  • Tax-free distributions. If you use the money for qualified education expenses, you don’t have to worry about federal income taxes (or, in some cases, state taxes).
  • Limited control over investments. Although you can choose from a set of investment options, this is not a self-directed account.
  • Accelerated gift tax treatment. You can contribute up to five-years-worth of $15K annual contributions without triggering a gift tax.
  • Low student aid impact. Even though the child is the legal owner, the assets are usually considered as the parent’s money as long as the child qualifies as a dependent.
Cons
  • Only cash contributions. However, you can rollover assets from another 529 Plan, custodial accounts, or a Coverdell Education Savings Account.
  • Contribution limit. 529 Plans are required to have a total contribution limit, but the amount varies by plan.
Pro tip: Consider putting the 529 in the name of a grandparent or another relative. Money in a 529 plan that is not in the name of custodial parent doesn’t get reported on the Free Application for Federal Student Aid (FAFSA) form. In such cases, distributions are untaxed income for the beneficiary.

529 (ABLE) Plans

529 ABLE plans stand for Achieving a Better Life Experience and focus on the low-income disabled. The goal of these accounts is to give the low-income disabled a tax-deferred savings account to pay for educational and other expenses with tax-free dollars. One of the best things about ABLE accounts is that disbursements don’t found as income for asset-tested programs, such as Social Security and Supplemental Security Income benefits.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of 529 ABLE plans

Pros
  • Do not disqualify you from asset-tested programs. 529 ABLE disbursements don’t affect your eligibility for Social Security and Supplemental Security Income.
  • Tax-deferred earnings. As long as you use the money for education expenses, there is no tax on the income generated.
  • Tax-free distributions. If you use the money for qualified education expenses, you don’t have to worry about federal income taxes (or, in some cases, state taxes).
Cons
  • Contribution cap. There is a maximum annual contribution of $15K per account.
  • Only poor and disabled taxpayers qualify. You are considered disabled if you are diagnosed before you’re 26 years old with a disability that will impari9 you for at least 12 consecutive months.

Series EE and Series I U.S. Savings Bonds

Series EE and Series I U.S. Savings Bonds provides tax-advantaged savings accounts if you use the money for qualified higher education expenses. They are basically Treasury bonds for education expenses. The main difference between them is that Series I bonds have an inflation adjustment are built into them.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of Series EE and Series I U.S. Savings Bonds

Pros
  • Small minimum. Bonds can be bought in $25 increments.
  • Tax-deferred earnings. As long as you use the money for education expenses, there is no tax on the income generated.
  • Low student aid impact. These bonds must be in the name of the parent’s name, so they don’t count as student assets for financial aid.
Cons
  • Age restriction. The buyer has to be 24 years or older.
  • Filing requirements. Married persons must file jointly to qualify.
  • Contribution limit. Maximum contribution of $10,000 a year.

Trust accounts

There are several types of trusts you can use to pay for education expenses, but 2503(c) trusts are probably the best-known. Trusts work similarly to custodial accounts with some additional bells and whistles.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of Trust accounts

Pros
  • Small minimum. Bonds can be bought in $25 increments.
  • Gif tax exclusion. Contributions qualify for the annual gift tax exclusion.
Cons
  • Loss of control. The child can access the money when she turns 18 or 21.
  • Kiddie tax. If money from the account is distributed, it is taxed at the child’s rate, which can be the same as the highest marginal rate of the parents.
  • Irrevocable contributions. Once a contribution is made, it cannot be taken back.
  • Reduces student aid eligibility. The money is considered as the student’s asset, so it will negatively impact how much student financial aid she will qualify for.

Individual Retirement Accounts (IRAs)

Most people use IRAs for retirement, but both Traditional IRAs and Roth IRAs can be used to save for college costs using a loophole not many people know about. Usually, you have to pay a hefty penalty if you withdraw money from an IRA before you’re 59-1/2 years old. However, you can avoid this penalty if you use the money to pay for educational expenses for your spouse, your kids, your grandchildren, or yourself.

Traditional IRA contributions are often tax-deductible, but in such cases, you will have to pay taxes on the money you withdraw. This is a good option for people who expect to be in a lower tax bracket when they need the money. Roth IRAs are not tax-deductible, but your money grows tax-free, and there are no taxes on distributions, which makes them attractive to people who expect to be in a higher tax bracket when they need to access their savings.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of IRA accounts

Pros
  • Tax-deferred growth. Both Traditional and Roth IRAs offer tax-deferred growth.
  • Tax-deductible/Tax-free withdrawals. Traditional IRAs reduce your current tax liability now, while Roth IRAs give you tax-free savings in the future.
  • Very favorable for student financial aid. Assets in IRAs don’t count as available assets for financial aid purposes.
  • Maintain control over the assets. Parents get to decide when and how to use the money.
  • Wide investment selection. You can invest the money earmarked for education the same way you invest the rest of your retirement accounts.
Cons
  • Contribution limits. In 2020, the contribution limit is $6,000 ($7,000 if you’re over 50).
  • Income limits. There are no income limits on Traditional IRAs, but Roth IRAs are phased out for taxpayers with high incomes. In 2020, phase-out starts at $124K for single filers and $196K for joint filers.

Step 3: Consider educational expense income tax benefits

Tax laws change from year to year, so it is essential to check what is now available. As of 2020, these are the tax benefits available to reduce the cost of education expenses.

The American Opportunity Tax Credit (AOTC).

Tax credits are an amount of money that taxpayers can subtract from taxes owed. Notice that deductions and exemptions reduce the amount of taxable income. However, tax credits reduce the actual amount of tax owed, dollar for dollar.

The AOTC  is a tax credit and applies to 100% of qualified tuition, fees, and course materials paid by the taxpayer for qualified education expenses, up to $2,000 plus 25% of the next $2,000 of expenses. In other words, the maximum AOTC is $2,500. An important advantage of this credit is that it’s applied on a per-student basis. So families with multiple people attending college or a vocational school can claim the credit for each family member.

However, this credit is only applicable to the first four years of post-secondary education. Also, you can’t claim both the AOTC and the Lifetime Learning Credit in the same year. The credit phases out for high-income taxpayers (modified AGI of $80,000-$90,000 and joint filers with modified AGI of $160,000-$180,000).

Lifetime Learning Credit

The Lifetime Learning Credit is similar to the American Opportunity Tax Credit. It allows families to claim a tax credit for qualifying education expenses or for expenses associated with part-time classes at a qualifying educational institution taken to improve job skills. Families can claim a credit of 20% of the first $10,000 of qualifying tuition and fees. The maximum credit maximum is $2,000 per family, not per person.

Remember, you cannot claim the AOTC and the Lifetime Credit for the same student during the same year. This credit also phases out for high-income taxpayers. In 2020, the credit begins to phase out for single filers with modified AGI of $59,000 and joint filers with modified AGI of $118,000.

Student loan interest deduction

Any interest you pay on student loans (private and federal) for qualifying post-secondary education and training expenses is deductible in calculating adjusted gross income. A big advantage of this deduction is you don’t have to itemize deductions to benefit from it. The maximum deduction in any one year is $2,500. This credit also phases out for high-income taxpayers.

Business deduction for work-related education

You can deduct work-related education expenses as a miscellaneous itemized deduction as long as certain miscellaneous deductions account for more than 2% of your adjusted gross income (AGI). If you’re self-employed, you can deduct the qualifying education expenses from your self-employment income. A great advantage of this deduction is that you can usually claim it in addition to the tax credits and deductions listed above.

Tuition and fees deduction

This deduction allows you to deduct up to $4,000 in qualified tuition and fees for yourself, your spouse, or dependents. Notice that this deduction expired at the end of 2017 but was reinstated for tax years 2018 through 2020. Single taxpayers with AGIs above $80K and joint filers with AGIs above $130K get phased out of this tax benefit.

Start saving for college

Now you have an idea of how much it will cost, the best savings vehicles for your family, and what tax benefits you can claim, it is time to implement your strategy.

If you can’t afford to save the entire amount, don’t be discouraged. You don’t have to be the only source of your child’s college savings. Student loans are always an option. You can apply for scholarships (we have one for personal finance activists) and you should get your child to chip in with her own savings account. She can also reduce the cost of attending college by taking advanced placement classes in high school. That way she can earn college credits at high school prices.

The most important thing is to get started. Open a savings account today at your bank, credit union, brokerage,robo-advisor, or investment advisor of choice and start putting your education savings to work.