“And as with any investment, but especially with college savings plans, it’s always best to begin putting aside money as soon as you can.”
This tagline from U.S. News says it all. It doesn’t matter what you put your money into to save for college — starting as early as possible is universally the best decision you can make.
But, when exactly should your financial plan begin for funding college? Ideally, it’s best to start when you’re thinking about having children.
However, it’s most likely that more than a few years have passed since that time in your family’s life. So, let’s turn our thoughts from when to where. Here are my top 11 suggestions for the best places to save money for college tuition.
How To Save Money For College Tuition – The Top 11 Places
1. Section 529 College Savings Plans
These are government plans with advantages and disadvantages.
If the 529 Plan makes money, the gain is tax-free if the funds are used for the specific purpose of paying for qualified education expenses. Some states even allow you to deduct your 529 contributions from your state taxes.
Now for the disadvantages. Investment choices are limited to certain mutual funds and fixed accounts. The 529 Plan is not liquid (cash available); if you take out money that is not qualified, it’s treated the same as an IRA. The profit is taxed and there is a 10% penalty as well since most parents of college-aged students are not over age 59 ½.
Another major drawback to Section 529 is that it must be reported on the FAFSA and the amount of money in it is assessed at 5.64%, increasing your Expected Family Contribution (EFC) by that amount every year that it stays in the 529. In other words, it increases your college costs.
2. Coverdell Education Savings Account
A Coverdell account has the same advantages and disadvantages as a Section 529 Education Savings Account.
Unlike 529s, which limit your investment choices to certain mutual funds and fixed investments, a Coverdell allows you to choose your own investments. The downside is that your contributions are limited to $2,000 per year.
3. Bank and Credit Union Accounts
These have the advantage of being safe and liquid (cash available). However, historically they have the disadvantage of a relatively low return that grows considerably more slowly than college costs are increasing.
Bank and credit union accounts have an even larger disadvantage — they are assessable on the FAFSA, causing you to pay 5.64% of the account value more for college than you would if you didn’t have your college funds in there.
4. U.S. Saving Bonds
Bonds have the advantage of high safety, liquidity (including some ability for qualified withdrawals), and some small tax advantages. They have the same disadvantages as bank and credit union accounts, i.e., historically low returns below college cost increases. Finally, they are assessable, causing parents to pay 5.64% of the account value more for college.
5. Child’s Custodial Account (UTMA or UGMA)
There are small income tax advantages but large FAFSA disadvantages to the parents of college-bound children. Money in a child’s name is assessed at a 20% level.
Also, your student better be a responsible adult by age 18, when the account becomes legally theirs. You will want to use this up as soon as possible.
6. Stocks and Stock Mutual Funds
These vehicles have the advantage of yielding potentially high returns that will go up more than the cost of college does. They are also relatively liquid.
Stock mutual funds have the disadvantage of risk, as do stocks, but they also have another substantial disadvantage — they frequently automatically pay out dividends that are reported as income. Income is assessed on the FAFSA at about 47%, which obviously could substantially increase the amount that you would pay for college.
7. Contribute More to Your Retirement Plans
Even though this move may appear advantageous on the surface because money in a retirement plan as an asset is not assessable on the FAFSA, there is a larger problem.
When money is initially placed in a retirement plan, it’s assessed as income at about 47%, because it is added back and counted as income on the FAFSA. To make matters worse, funds placed here are relatively illiquid, making this a poor choice for funding college.
8. Put Money into a Roth IRA
This is advantageous because it is being invested into a retirement plan that is not assessable on the FAFSA. Also, the interest earned is tax-free and the principal (the money you put in) is available without penalty.
However, it does have several disadvantages.
There is an earnings limit on who is eligible to contribute to it and there is a limit to how much you can put in. The largest disadvantage is that if you withdraw non-qualified gains you will trigger income. This is very bad; this income on the FAFSA will be assessed at about 47%. In other words, you will pay 47% of the non-qualified money you take from your Roth IRA more for college.
There are exceptions, but be careful, it is complicated.
9. Home Equity Line of Credit
A HELOC can be very advantageous to create liquidity.
If you have a school that uses the Federal Methodology on the FAFSA, you can put money into your house by paying down your mortgage. This will cause a savings of 5.64% of the amount of the asset you make disappear into your house; it is legally “FAFSA blind.”
The disadvantage — if you actually take money from your HELOC, you will pay interest if you use it.
10. Paying Down Your Mortgage
This choice of college funding is tied to number 9.
If you do pay extra money into your house, you need to make it liquid (cash available) by opening up that HELOC, so you can access it.
The disadvantage to this option is that you lose control of your money; you must work with the bank to get your money out to pay for college.
11. A Legacy Fund
Setting up a cash-building life insurance policy may at first sound strange. Since this option is a little complex, I recommend that you use a financial advisor who has an in-depth understanding of how to design these policies for college funding purposes.
Ironically, this college funding choice seems to have the most advantages of all the viable alternatives because it has multiple positive features. It’s called a Legacy Fund because it has life insurance and a long-term care disability advantage for your family included in the contract. If you are fortunate enough that you don’t need to use the funds for college expenses, this fund can become an emergency fund or a supplemental retirement fund.
Safety and a relatively high return can also be advantages if an Indexed Universal Life policy is chosen. (A topic for another time.) Also, a properly managed Legacy Fund will help you save money, which will grow tax-deferred and will ultimately be entirely tax-free, similar to a Section 529 College Savings Plan. The largest Legacy Fund advantage is that it is “FAFSA Blind”. This means any money built up in this fund doesn’t get assessed because it is not legally required to be reported on the FAFSA.
As with all the other options, there are disadvantages. The cost of insurance and policy fees must be paid every year. If you don’t need the life insurance and long-term care features of this plan, or cannot qualify for it, this plan may not be for you.