Choosing the right college savings account can feel overwhelming. With at least half a dozen different types of college savings accounts, all with unique sets of complex rules, it's tough to even know where to start.
Ultimately, the right type of college savings account can be selected by asking yourself a few simple questions. Since each account has its unique features and benefits, your answers will pretty much make the decision for you.
Question #1: Do I prefer a safe but lower rate of return over something that may grow faster, but also expose me to potential losses?
If safety is your primary concern, you won't need to look much further than a Section 529 Prepaid Tuition Plan. These plans let you buy tuition in today's dollars, and are guaranteed by the issuing state to give you an equivalent amount of tuition at some point in the future.
From a safety perspective, the state that runs such a plan would have to go bankrupt for you to lose your investment. That's as safe as you'll find without buying US Government Bonds.
From an investment return perspective, it's unlikely to outperform a portfolio that has stock market exposure, but will likely outperform other "safe" college funding options. Since the historical rate of college inflation is close to 6%, a better investment would need to show the same level of safety but a higher rate of return.
Series EE and Series I bonds historically have earned 3-6%, which leaves them lagging behind the Section 529 Prepaid Tuition Plans. Buying individual bonds in a UGMA / UTMA account might get you close to the return of prepaid tuition plan, but will be subject to taxation on any interest earned above a certain amount. Using bond mutual funds in any of the other savings plans may offer an equal historical rate of return, but will also be subject to volatility and potential losses.
Since most states' plans primarily cover public colleges and universities, you might want to consider the Independent Section 529 Plan if you think your child will attend a private school.
Question #2: Assuming you prefer higher rates of return... Does your state offer incentives for using its in-state Section 529 Savings Plan?
Considering that many of the states essentially put cash back into your pocket for using their Section 529 Savings Plan, it would seem foolish to not take advantage of it. Most often, this incentive comes in the form of a deduction or credit on your state income tax return. Some states however, like Arkansas, actually match its residents' contributions to the plan, up to certain limits.
Since many of the states offer at least one or two good long-term stock market options in their savings plans, it's probably wise to take the "free money." Even if you don't have access to your favorite mutual fund, this initial boost will lift your returns over time.
Question #3: Assuming you prefer higher rates of return and don't receive any in-state incentives to use a Section 529... Do you expect to save more or less than $2,000 per child per year?
If you think you'll save less than $2,000 per year (the maximum allowed contribution to a Coverdell ESA), it's unlikely that you will accumulate more than you'll actually need for college. Since you'll likely spend the majority of the funds you save, you probably won't have to face the possibility associated with a Coverdell of having to give a child the leftovers at age thirty.
Since the Coverdell ESA offers much more freedom in selecting your investments, as well as much looser standards on how the money gets spent (including tuition for grades K-12), this account will probably better fit your needs.
The case for a Coverdell gets even stronger if you have multiple children. This comes from the fact that you can transfer unused funds down to another Coverdell account, or use the funds to set up a new one for other family members, including grandchildren.
If you decide that you want to save more than $2,000, then it pretty much guarantees that a Section 529 savings plan is going to be your best choice. The only caps placed on contributions to Section 529 savings plans are "lifetime" totals for each child.
With lifetime maximums that range from the low $100,000's to over $300,000, most parents can contribute to their hearts' content. Even better, these sums grow tax-deferred and may be potentially withdrawn tax-free.
Best of all, the Section 529 accounts allows the assets to remain under a parent or donor's control forever. They're even allowed to take the assets back for personal use.
Question #4: What about UGMA's, Roth IRA's, and trusts?
While these vehicles offer some unique planning opportunities, they will not serve most families as well as Section 529 plans or Coverdell ESA's.
UGMA and UTMA custodial accounts count almost four times as heavily against financial aid, and require the assets to be handed over to a child no later than age twenty-one.
Roth IRA's offer virtually the same tax benefits as a Coverdell ESA or a Section 529 account, without wasting a valuable opportunity to save for your retirement.
Trusts, while they sound impressive, are extremely expensive to set up and run. They don't need to be considered unless you want to exceed the maximum allowable contributions to a Section 529 plan.