4 Ways to Save for Your Child’s College Education

[This is article three of three in my saving for college series. Click below to see the previous two.]

• Why You Should Save for Your Child’s Education…and Why You Shouldn’t
• Saving for Your Child’s Education: Making the Right Decision

Now that I’ve taken the extreme liberty of writing only about college savings for the past two weeks, today I’m going to close my thoughts with a few different ways you can save for your child’s education. It’s time to start making those decisions of action. Your dollars aren’t going to save themselves for your kids on their own. Once you can conscientiously make the decision whether or not you’re going to do it, you need to do it.

Here are just four ways you can start:

529 Plan

This is probably the most popular way to save for college education. There are actually two different types of 529 plans, depending on the state you live in: Prepaid tuition plans and college savings plans. But just because it’s common doesn’t mean it’s necessarily the best alternative in every situation:

Pros

• Your investment grows tax free, meaning that as long as the money is used for education-related expenses, you don’t have to pay taxes on the growth of your investment.
• Unused amounts can be transferred to another family member without incurring a penalty.
• Some states allow you to deduct some or all of your contributions when filing state income taxes.
• You can purchase “credits” at today’s tuition rates that grow with the rate of tuition, taking the volatility of the market out of the equation (prepaid tuition plans only).
• Contribution limits are quite high (more than $200,000 in most cases).
• You are in full control of how the money is spent.
• You don’t have to go with your state’s plan.

Cons

• If you use the funds for anything other than education, not only do you have to pay taxes on the growth, you’ll also get burned with a 10% penalty. This is especially annoying if you end up saving more than your kids need.
• You can’t manage the money yourself.
• Investment options are very limited (most are very conservative).
• You can change the allocation of your investment only once a year.
• Using a 529 to pay tuition can reduce the student’s eligibility for need-based financial aid.

Overall, the 529 looks pretty good for those willing to commit to a set plan and invest conservatively. However, it’s horribly inflexible when it comes to how you invest your contributions and what you can do with the earnings.

Coverdell Education Savings Account (ESA)

In general, an ESA is similar to a 529 Plan, but there are differences that may make it a better or worse choice, depending on your situation:

Pros

• Contributions grow tax free.
• Unused funds can be transferred to another beneficiary (must be a family member).
• In addition to college expenses, funds can be used for elementary and secondary school expenses (private school anyone?).
• Your investments are self-directed and there is a very broad selection of investment products.

Cons

• Funds must be completely disbursed by the time the beneficiary turns 30 or transferred to another family member, otherwise your earnings face taxes and a 10% penalty.
• The maximum contribution limit is just $2,000 per year per child (peanuts compared to the 529 plan).
• Contributions cannot be made once the beneficiary reaches age 18.
• Typically, the beneficiary takes control of the account one he/she reaches 18 (meaning your son could drain the account and take a month-long trip to Europe with his buddies instead of using it for his education).
• People in high income brackets may not be able to contribute.

For those of you who, like me, enjoy getting their hands dirty with this kind of stuff, the self-directed investing sounds great. And if private school is in the cards, here’s a good opportunity to start the tax savings off early. But it looks like in every other way, the ESA is even less flexible than the 529 plan.

Whole Life Insurance

Whoa. OK. You just bristled when you read that. I know, whole life insurance is a HOT topic these days. And I’m willing to put myself out there and tell you that there are some instances when it’s a good product to have in your own toolbox.

But getting it on your kids? Really? Hear me out. I’ll go directly to the pros and cons before you interrupt me:

Pros

• The cash value is guaranteed to grow and isn’t tied to the stock market (most insurance companies don’t sell a good whole life product, so for most companies, that rate of return sucks. I use Northwestern Mutual, which has the best whole life product out there. The rate still doesn’t compete with stocks, but it’s not horrible).
• It provides your child with a death benefit, which can cover expenses associated with that horribly tragic event.
• If, for some health-related reason, they can’t qualify for life insurance when they’re older, they at least have something.
• The cash value grows tax deferred.
• You can borrow against the cash value or surrender the policy at any time without a penalty.
• You don’t have to use the money for education expenses (In fact, if you decide to keep it all, you can).

Cons

• The rate of return can’t compete with the market.
• Earnings grow tax deferred rather than tax free. Still tax-sheltered product, but not as nice as tax free.
• Cash value growth is slow, meaning you may barely break even by the time your child hits college.
• Since whole life technically can’t be considered an investment, the government will only allow you to put so much in a life insurance policy before they treat it as a fully taxable product.
• No control over the growth of the cash value.

This one is definitely tricky. You have to be careful when talking to insurance agents about whole life insurance because they tend to make the most money off of those policies. In some ways, it offers more flexibility than the 529 and ESA in how you can use the money, and it also has that insurance component (yes, I know your child has no income, but funerals cost money no matter how old you are). The only reason you should use this is because you value that insurance component in addition to the cash value growth, because the low rate of return isn’t compelling enough on its own. If you do decide to use whole life insurance to save for your child’s college education, don’t let it be the only way you’re saving.

Straight Up Investing

If you don’t want to deal with the inflexibility of any of the aforementioned products, you can simply take advantage of the markets. For example, you could buy your kid Disney stock (one of the best buy and hold stocks out there, in my opinion). Or you could set up an Acorns account like I just did. The opportunities are endless.

Pros

• You can invest as much and however you want.
• You can use the earnings for whatever you want.

Cons

• If the economy tanks, so does your child’s education savings.
• Your earnings will be fully taxable (although you can invest in tax-free municipal bonds, but the rate of return isn’t great).

There’s obviously some added risk when it comes to just straight up investing without the cover of a vehicle like a 529 or ESA, but there’s also the potential of a higher reward over the long term. For our situation, I’ve already purchased a whole life insurance policy for our son, and I’ve also decided for the flexibility of investing without a 529 or Coverdell. Texas doesn’t have state income tax anyway so there’s no other reason why investing in a 529 would be enticing to me. Personally, I don’t like the constraint of those two products, and from what I’ve seen other people experience, having the life insurance is important to me.

However, what works for me may not work for you and vice versa. Do you already have a savings plan for your child’s college education? How are you doing it?

(photo cred)