The government provides two different kinds of tax-advantaged college savings vehicles. In this post we discuss their features and how they compare to each other.
Last week I wrote about things you should do after having a baby. One of the things I mentioned was saving for college and I got a lot of questions about it. We all know we should be saving for our kids’ education, but for most of us, that’s the extent of our knowledge. How do you save? What are your options? Where do you put the money? How do you even open an account?
Today I’ll go into more detail about what your options are and how you can make the most of the money you are working hard to save.
Use A Tax-Advantaged Account
Anyone can save money in a simple savings account. There are two problems with doing that, though. First, you hardly earn any interest on your money. When you factor in inflation, your money is actually worth less after sitting in a savings account for awhile. Second, you have to pay taxes on any interest you do manage to earn.
Usually, we think of taxes as an inevitable part of living in a civilized society, but when it comes to college savings they don’t have to be! The government has provided two different options for saving where you don’t have to pay any taxes on the growth.
Coverdell Educational Savings Account
The first option is the Coverdell Educational Savings Account (ESA). Sometimes called Educational IRAs, these work a lot like IRAs do for retirement except that they are used to save for qualified educational costs. If your income does not exceed the limits, you can open one for anyone under the age of 18 and contribute up to $2,000 each year. A beneficiary may have multiple accounts, but $2,000 is the limit that can be contributed annually from all contributors combined.
The best thing about an ESA is the investment flexibility. Just like an IRA, they can be invested in any number of stocks, bonds, mutual funds, etc. and the person that opens the account makes all of the investment decisions. Another noteworthy feature of the ESA is that it isn’t just used for college, it can be used for K-12 education as well.
The second tax-advantaged savings option is called a 529 plan, or Qualified Tuition Plan. They are offered by states or educational institutions and get their name from the section of the Internal Revenue Code that authorizes them. Every state sets up their plan(s) differently, and you don’t have to be a resident to participate in a state’s plan.
These plans are great because they usually have no annual contribution limit (only high lifetime limits), no age limits and no income limits. Anyone can contribute to them. Also, many states offer tax deductions for residents who invest in their state’s plan.
Types of 529 Plans
There are generally two types of 529 plans; savings plans and prepaid tuition. Savings plans work just like most retirement accounts. You choose from several available investment options and then your account balance goes up and down based on how those investments perform.
Prepaid plans are a way of pre-paying tuition for an in-state public college. They can usually be converted to cover out-of-state or private tuition as well.
Which Type Is Better?
Since you can choose from any state’s plan, you have a lot of options. Which kind of plan is better? Let’s look at the math. Over the last 10 years, the cost of college has gone up about 5% a year. So, if you prepay, you essentially get a 5% rate of return. That’s much better than just a savings account! But is it the best you can do?
If you were to go for a savings plan, you could invest in the S&P 500, or an index fund that tracks it. From 1928-2014 the S&P 500 averaged about 10% a year. That’s twice what you would get with prepaid tuition. Double sounds good, but doubling the rate of return doesn’t just double how much money you have. Thanks to compounding interest, doubling your rate of return means you would end up with more than twice as much money.
Basically, the kind of investment you choose for your savings plan will dictate whether it is better or worse than a prepaid plan. A plan that earns you more than 5% a year will make your money go farther than it would in a prepaid plan.
Most of my readers are in the Pacific Northwest, so let’s take a quick look at Oregon and Washington’s 529 plans:
Oregon 529 Plan
The Oregon College Savings Plan is a savings plan that offers age-based portfolios, guaranteed portfolios, multi-fund portfolios and single-fund portfolios. You can see the historical performance of the different options here, and you’ll see that they range from near 0 to over 12%. Money held in an Oregon 529 can be used at any accredited college or university nationwide.
Contributions to the plan are deductible for Oregon state income taxes. The lifetime maximum contribution is $310,000, but you only need $25 to open an account. To make saving easier, they offer automatic payroll deductions of as little as $15 a month. Accounts can be opened online through their website in about 15 minutes.
Washington 529 Plan
Washington state’s 529 plan is called GET, Guaranteed Education Tuition and is a prepaid tuition plan. It is currently closed and scheduled to reopen July 1, 2017. It was closed in response to the College Affordability Program that lowered tuition at public colleges and universities in Washington.
Though the plan guarantees tuition for state schools, the money can be used for attending schools out-of-state. Tuition levels vary by state and school, so your money may not go as far in another state as it would in Washington.
ESA & 529 Plan Comparison
Here is a chart to give you a better idea of how the two plans compare:
Both kinds of plans are treated the same way for Federal Financial Aid purposes. Also, they are not mutually exclusive. You can open both kinds of plans for your children or other beneficiaries.
What I Use Personally
Right now we have ESAs for each of our children. They are both invested in a mutual fund that has been around for just under 60 years and has averaged 11.3% annual returns over that time. I chose an ESA so that I would not be limited in my investment options. I do plan on doing further research to try to find a 529 plan that would give me comparable investment options, but I haven’t yet.
Now Take Action!
Hopefully the information here has given you a better understanding of your college savings options. Now it’s time to take action, choose one and start saving! Next month I will discuss how to analyze the different investment options and choose the one that’s best for your unique situation.
If you choose to open an ESA, there is still time to make contributions for 2016. You have until tax returns are due (April 18 this year) to make contributions for the previous tax year.