• Saving for College: 529s and All That

    This is the final post (for now) in a series on saving for college. In prior posts I covered the issues of (not) putting money in your child’s name and of how much to save per month. In this post I discuss what investment vehicle(s) to use and which to avoid. I should note that I’m writing with college savings in mind, but all of what follows applies to paying for expenses for other types of higher education (e.g. graduate school).

    Many books and websites will break down the pros and cons of account type options for college savings. For me and likely the vast majority of people there is only one choice for most college savings: 529 savings accounts. I’ll explain why by first describing what makes the other choices less advantageous.

    We can eliminate UGMA/UTMA accounts right off the bat. Those are for saving money in your child’s name. As I wrote in Saving for Minors, for college savings there is a big disadvantage to saving in your child’s name: it dramatically reduces the level of financial aid for which your child will be eligible.

    My next least favorite way to save for college are Coverdell accounts. Coverdell accounts used to be a particularly good way to save for private elementary and secondary school (for which the funds can be used tax free before the end of 2010 only). But there are some limitations of Coverdell accounts that make them less advantageous for college savings as compared to 529s including: contributions limited to $2,000/year now and going down to $500/year after 2010, are not tax deductible in any state, cannot be made if the beneficiary is 18 years old or older, and the account must be liquidated by the time the beneficiary reaches 30 years of age. However, Coverdell accounts do make sense in certain circumstances, but I think such cases are rare.

    An IRA, and in particular a Roth IRA, can be a good way to save funds for college, with one catch: it is also a good way to save funds for your retirement. You can withdraw any and all contributions to a Roth IRA tax free at any time. You may also withdraw the earnings penalty (but not tax) free if used for college education expenses. Roth’s have contribution limits (currently $5,000/year) and not everyone can establish one (there are AGI limits and earned income requirements). Since a Roth has so many advantages it makes sense to fully fund one for your retirement, if not for your child’s college education. But if you need your Roth funds for retirement then you won’t want to rely on them for college expenses.

    Income earned from series EE and I U.S. Savings bonds can be used tax-free for higher education expenses, with some restrictions based on AGI. One can only purchase $5,000 per year for each type of bond (actually, I think it is $5,000 electronically on TreasuryDirect and $5,000 on paper, for a total of $10,000). I bonds also have the property of being inflation indexed. For this reason I have purchased I bonds for part of my emergency funds. I may use those for college expenses to avoid taxation on the earnings. Of course the main disadvantage of bonds for college savings is that they are just bonds. That’s not a diversified portfolio.

    Finally, we arrive at 529 savings plans. These plans do not suffer the limitations I describe above for the other types of vehicles. And they have many nice features: the income and returns are tax free for qualified college expenses, contributions are tax deductible in many states, the owner (parent, grandparent) retains control and they are not considered assets of the student for financial aid purposes, there are a great variety of plans to choose from with many mutual fund options available, there are no AGI limitations to investment or use, and the contribution cap is very high (currently $13,000 per parent per year, though you can compress up to five year’s worth of contributions into a single year).

    Obviously I like 529s. I’m not alone. They’re very popular and are recommended for college savings by many financial experts.

    My recommendation to most individuals wishing to save for their child’s college expenses is to (1) fully fund your own retirement needs first, including maxing out Roth accounts to the extent eligible, (2) invest most funds in a 529 savings account with perhaps, (3) some in EE or I savings bonds. (However, because there are AGI limitations on their use for tax-free college spending, I only recommend savings bonds if you have a sound secondary purpose for those bonds, e.g. as a component of retirement or emergency fund savings).

    Here are a few sources for additional reading on savings vehicles for education expenses:

    • About that “$12,000 per parent per year” contribution cap, isn’t it $13,000 per year per contributor per beneficiary? The person contributing to a 529 does not have to be a parent. If there are three children, each child gets a $13,000 per year cap from each contributor (parent, grandparent, aunt, etc.).

      • @TFB – The source I cited says $12k. That doesn’t make it right. It could be out of date. It follows the gift tax rules, right?

        Anyway, if you are aware of something that documents the cap at $13k, please share it (URL). Would that also imply one can contribute five times that amount in one year and none for the next five years (i.e., $65k)?

        Good point about non-parent contributors.

    • Gift tax exclusion: http://www.irs.gov/businesses/small/article/0,,id=108139,00.html#5

      Bunch five years worth of gifts in one year: http://www.irs.gov/instructions/i709/ch02.html#d0e849 (wait for 2009 form 709 instructions for updated numbers for 2009)

    • @TFB – Thanks. I updated the post and cited your comment as the source 🙂

    • What about States that offer prepaid programs, like Florida?


      Most people I talk to utilize the prepay for tuition and the 529 for ancillary expenses. In your view, is there more upside to taking the lump sum, prepaid money and investing it in the 529 at birth or soon thereafter, or is the security of the prepaid worth more?

      • @Samples – I’ve looked into some pre-paid options. They all have some strings. If you know your child will go to a particular school or one of a set of schools covered by the plan then it may make sense. Since I am not qualified to broadly evaluate all such options I will not say more. Each individual should investigate these on his/her own. Perhaps others will have more to say about this or suggest a website that has better advice.

        One place to look and to ask questions is the Bogleheads Investment Forum. I know this topic has been discussed there. I’ve even participated in some of those discussions. All I recall with clarity right now is that I concluded for myself that I was more comfortable with a 529 than any prepaid plan I was aware of.

        See also this recent NY Times article: http://www.nytimes.com/2009/10/05/education/05college.html?_r=1