In the United States, raising children can be a costly endeavor. While it’s difficult to pinpoint an exact figure, most economists estimate the annual cost of raising children in the US is about $16,000 to $18,000 per year. However, this number doesn’t factor in the cost of college, which can be relatively high, depending on where your child wants to go. According to recent data, the average cost of attending a 4-year, in-state college and living on campus per student is around $27,146 per year.
Because your children’s education is essential, now is the time to start thinking about a college savings plan. Even if your little one is still a newborn, it’s never too early to save money. Thankfully, the sooner you start, the more options you have, so let’s discuss the different ways you can start saving for higher education.
What are College Funds?
A college fund is exactly what it sounds like—a fund you use to pay for higher education. This fund can cover everything from tuition to dorm rentals to textbooks: anything college-related that comes with a price tag.
One of the most important details to know when understanding college funds is that you don’t want your money to just sit in the account. Depending on when you open the account, you may have up to 18 or 19 years before you’ll need the cash, so it should be growing the entire time.
But why is it so important for your college fund to grow? The cost of higher education es expected to increase. So, if your money doesn’t grow, you’ll wind up with less than what you need. Fortunately, multiple types of college fund accounts can help keep your money working for you until your child needs it.
The Four Types of College Savings Accounts
When building a college savings plan, you should try to take advantage of multiple types of accounts. Each account type has pros and cons and it’s wise to diversify your portfolio to minimize risk and maximize gains. That said, one account will likely have the bulk of your college savings in it, while other accounts may have smaller amounts to cover expenses which may not be permitted by the primary account due to IRS restrictions.
529 Plan
For most parents, a 529 plan is probably the best way to save for their child’s college expenses. A 529 plan is an investment account that comes with substantial tax benefits and incentives. Compared to most other types of college funds, this plan may have the most financial advantages.
Here are the primary advantages of opening a 529 account:
- Anyone Can Contribute – Relatives, family, and friends—or anyone may contribute toward a child’s 529 college fund.
- Tax-Free Withdrawals – As long as the money is used for educational purposes (e.g., tuition, room, board, PC, internet connectivity, etc.), all withdrawals are federally income tax-free.
- Tax Deductible Contributions – With a 529 plan, you don’t get to deduct contributions against your federal tax return. However, states with income taxes offer varying deductions and credits.
- Flexible Beneficiaries – When setting up the account, you must name a beneficiary (i.e., your child). However, if they don’t go to school (or don’t need all the money in the account), you can name another beneficiary instead.
Overall, a 529 plan is ideal for covering most college expenses, making it the likely choice as a primary college savings vehicle.
Coverdell Educational Savings Account
A Coverdell Educational Savings Account (ESA) is another tax-advantaged investment account that you can use for college expenses. You may contribute to a Coverdell ESA if you are a single tax filer with MAGI of $110,000 or less or $220,000 or less for joint filers. No one can contribute more than $2,000 per year to the account. While you can open multiple ESAs, the contribution limit covers all of them. So, it’s $2,000 total across all accounts, not $2,000 per account.
This option may work best if you can’t contribute much toward your child’s education within a given year. As an investment account, funds follow the performance of the stock market. Withdrawals are tax-free (as long as they don’t exceed the total educational expenses for that year).
Up to $10,000 of 529 and Coverdell ESA funds may be used for K-12 education per year.
Custodial Account
A custodial account is one that you set up in your child’s name and manage until your child reaches adult age 18 or 21 (or 25 in some states). Unlike a 529 or Coverdell plan, the withdrawals are not tax-free, nor do you get to deduct/credit contributions (if the state has an income tax and allows that). However, because it’s a custodial account, there are no contribution limits, and you can invest the money however you see fit. Beware, once the account transfers over to your child, s/he can use the money however they see fit—not necessarily for educational purposes, including, for example, as a down payment for a house or to buy a car.
Typically, custodial accounts are best for parents who want to take advantage of the gift tax exemption. In 2025, individuals will be able to gift up to $19,000 ($38,000 for married couples) to a person without triggering income taxes.
Roth IRA
A Roth IRA is a useful tool for retirement planning, but some people also use it to fund their child’s education. The use of funds in a Roth IRA for a child’s education—K-12, college, or any type of education–would generally be limited to the already-taxed contributions. The gains in a Roth IRA are subject to a 10% penalty (on top of ordinary income tax) if funds are used prior to the Roth account owner’s age 59 ½. From a practical standpoint, that would limit the use of a Roth IRA for a child’s educational pursuits. Using Roth IRA funds would also deplete the retirement funds available to the parent.
Tips for Saving for Your Kids’ College Funds
How should you estimate how much to save for your child’s education so your child has enough? Here are some tips.
- Start Early – The sooner you start, the longer that money has to grow. Even small contributions can add up to over 18 years.
- Contribute Often – Small amounts like $20 and $100 can make a huge difference over time. Don’t assume that you have to contribute thousands of dollars at a time. Make saving habitual rather than a big nonroutine event.
- Get Help From Others – Ask family members or friends if they’d like to contribute to the account. Most relatives are eager to invest in a child’s future.
- Look at Assistance Plans – Explore scholarships, work-study programs, and assistance programs that can help cover gaps in your college fund.
- Automate Your Savings – If possible, set up an automatic withdrawal each month. This way, you never forget to add money to the account.
The Self-Completing Strategy
A life insurance policy can be used to ensure college costs are covered in two ways;
- If the parent dies prematurely—before the parent can save the full amount.
- By using cash value life insurance strategy to fund college.
Life Insurance for the Death Benefit
The odds may be against it but if a parent dies unexpectedly the child’s college dreams may be in jeopardy because funding is incomplete. The death benefit of a term or permanent life insurance policy can be used to fully fund a college education. Insurance coverage takes effect immediately so should the parent die, the college dream lives on—whatever the age of the child.
Life Insurance for the Life Benefit
Permanent life insurance policies may be designed to accrue cash value for the purpose of funding a child’s education. A death benefit is built into the policy to help ensure (and insure) the completion of the educational funding goal at any age.
- The policy owner can borrow against the policy using a tax-free loan.
- The funds are unrestricted so they have more utility than IRS-qualified vehicles like the Coverdell or 529 educational plans.
- If the child does not use any or all of the funds available from the life insurance policy those funds can be used for anything because this strategy is not education-specific.
- The policy is anyway designed to continue to grow, not end, after the child graduates college so this strategy may be used for other financial goals, including as supplemental retirement income for the parent.
Consult a financial professional to design the policy that’s right for your needs.
Planning for Future Success
There are many options available to help you fund your child’s education at any level, including K-12, vocational, international, and traditional college. The key is to start early and have a strategy. A MyStages® education funding consultant is available to help you identify and implement the strategy that optimally fits your needs and helps you pursue your child’s educational dreams.
