The cost of a college education can seem daunting. But the sooner you begin to save, the better. Small amounts of money, if invested early, can become sizable investments through the power of compounding.
And the good news is that there are a number of college savings options that offer tax advantages, such as earnings that grow tax-deferred and tax-free withdrawals on qualified educational expenses. In addition to the federal tax benefits of many college savings options, there may also be state tax benefits.
Regardless of the type of college savings plan you might choose, keep the following points in mind:
- College savings plans have fees and expenses that can affect your returns and should be considered when deciding what college savings options and underlying investments are right for you.
- Compared to saving for retirement, your college saving timeline is relatively short. At most, it may be 18 years. And for many people, it’s a lot less. This can impact your ability to weather a market decline and potentially increase your risk.
- Consider what will happen to your college savings if your child decides not to go to college, you have another child or you lose your job. These events and many others could dramatically impact your college savings strategy.
- Most college savings options have various restrictions and limitations that might impact your ability to react to a changing situation. Review carefully any college saving options to confirm that they have the flexibility and control you seek.
Ready to take the first step? Use our Education Savings Calculator to see how early and regular saving can make your money grow. When estimating future college costs, remember to factor tuition, room, board and books into your calculation.
If you know where you want your child to go to college, you can use the National Center for Education Statistics' school locator to research the current costs. If you’re unsure of where you want your child to go to college, you can learn more about general trends in college pricing from The College Board.
One way to save for college and other eligible educational expenses is through a qualified tuition program, also known as a 529 plan. Typically established and maintained by a state or an agency of a state, 529 plans provide opportunities for you and family members to contribute to future educational costs—including college tuition and qualified education expenses for higher education and private elementary and secondary education—and receive tax advantages.
There are two types of 529 plans: prepaid tuition plans and savings plans. Both allow earnings to grow tax-deferred, and withdrawals are tax-free when used for qualified education expenses, with some limitations. Prepaid plans also offer protection against rising tuition costs.
Most states offer at least one of these types of plans. Some states offer both, and many private colleges also offer a prepaid tuition plan.
Learn more about the differences between 529 savings and prepaid tuition plans to decide which type will best help you achieve your college savings goals.
Coverdell Education Savings Accounts (Coverdell ESAs) are a type of trust or custodial account that offers a tax-advantaged way to pay for education. Coverdell ESAs offer broader investment options than 529 plans, but contributions are limited. Custodial accounts allow a parent, grandparent or other custodian to make investment decisions until the child for whom the account was opened—the beneficiary—reaches a specified age.
As with 529 plans, contributions are not tax deductible. However, earnings in Coverdell ESAs are tax-deferred, and withdrawals that are used to pay for qualified education expenses are tax-free.
One advantage that Coverdell ESAs have over other tax-advantaged saving options is that you can make tax-free withdrawals to pay for eligible elementary and high school expenses (e.g., special needs services, tutoring and private school tuition), as well as post-secondary school expenses.
Except for investing in life insurance contracts, there are no investment restrictions for funds in a Coverdell ESA. You can set them up at almost any brokerage firm, mutual fund company or other financial institution. Keep in mind that, because of Coverdell ESAs’ fairly low contribution limits, even small annual fees or expenses could make a big difference in the value of your investment over time.
Series EE savings bonds issued after 1989 or Series I saving bonds are another tax-advantaged way to save for education. Backed by the full faith and credit of the United States government, the interest from these bonds is tax-free if used for qualified higher education expenses. Also, interest on Series EE and Series I savings bonds is usually exempt from state and local taxes.
The rules for using savings bonds for education can be complicated, and income limits apply (see IRS Publication 970: Tax Benefits for Education). Find the latest rates and other information about Series EE and Series I savings bonds at TreasuryDirect.
UGMA and UTMA Custodial Accounts
While not solely intended for college savings, Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) custodial accounts can also offer an avenue to save for education. Like Coverdell ESAs, with an UGMA or UTMA, a parent, grandparent or other adult is custodian for the account and makes all the investment decisions until the account beneficiary reaches the age of majority.
UGMA and UTMA accounts are largely the same, but the kind of assets you can contribute to them differs. UGMA accounts are limited to gifts of cash, securities (such as stocks, bonds or mutual funds) and insurance policies. UTMA accounts allow for the contribution of virtually any kind of asset, including real estate. Some states allow UTMA accounts, while others allow UGMA accounts. You can set up these accounts at almost any brokerage firm, mutual fund company or other financial institution.
College Tax Credits
The American opportunity tax credit (AOTC) and lifetime learning credit (LLC) offer two different ways to reduce your taxes while paying for college. You can find income thresholds and eligibility criteria for using these credits on the IRS’s website, along with a comparison chart to help you understand the similarities and differences between the two.
Note: If you’re eligible to claim the LLC, you’re also eligible to claim the AOTC. However, you can only claim one credit for the same student or the same expenses in the same year. To learn more, check out the IRS’s Education Benefits—No Double Benefits Allowed.
GI Bill Benefits
The GI Bill is a valuable benefit that has helped veterans pay for college since World War II. Eligible service members can receive money for tuition, housing and books to attend college or other educational programs and can claim benefits for up to 15 years after leaving the military. Learn more about how to activate your GI Bill benefits.
For many students and their families, loans are a reality of higher education. There are two broad categories: federal student loans and private student loans.
Federal student loans, which are administered by the U.S. Department of Education, have strict eligibility requirements and borrowing limits. They charge a fixed interest rate, and payments typically are deferred until after the student graduates. Interest on federal student loans begins to accrue when the proceeds of the loan are disbursed, but students who demonstrate financial need might be eligible for a subsidized loan. With a subsidized loan, the Department of Education pays the interest while the student is in school, for six months after graduation and during any period the student postpones payment on the loan (known as “deferment”), subject to the criteria set out by the Department of Education. To apply for a federal student loan, you’ll need to complete a FAFSA form.
Private student loans, which are issued by non-governmental lenders, have fewer eligibility and borrowing restrictions but usually charge variable interest rates that are often higher than those available for federal loans. In addition, origination and disbursement fees can be high, interest accrues during the student years and repayment options tend to be more limited.