Best Ways to Start Saving for College

Saving for college is likely on the financial priority list for those who have (or plan to have) children, but so are a lot of other things that seem more immediate. Things like saving for a house, retirement, or a car. Feeding and clothing the kids so they make it to college matters, too.

College costs should not be ignored, though. The average annual cost of a four-year school is $36,436, which covers tuition, books, supplies, and daily living expenses. That means four years of Philosophy 101 and/or majoring in Chemistry is going to cost you $145,744.

Costs rarely decrease. From 2010 to 2022, costs at four-year institutions increased 9.24%.

Yes, that seems overwhelming in a heart palpitation kind of way, which is why it’s important to start saving as soon as possible. Any savings now will alleviate putting student loan debt on your son or daughter in the future.

Consider getting the kids involved when they’re old enough. It’s never too early to teach kids about money.

The sooner you begin the better. If it fits your budget, early college savings means less money you will have to save each month and the higher the return you will earn. (Yes, it’s also important to make sure you are saving for retirement and have other priorities covered.)

How to Start a College Fund and Types

Many factors go into which is the best way to save for college and how much a month you should save.

There are many choices for those pondering college savings. The best account for each person depends largely on a saver’s financial situation, how much they want to save, and how much they’re able to save.

Here are some of the most common and effective ways to save for college.

1. Regular Savings Account

An old-fashioned savings account at a bank or credit union is a time-honored way to save, though it also can seem right out of “It’s a Wonderful Life.”

It’s important to pay attention to the interest rate a financial institution will give you for savings. In the years of low interest rates, savings account interest nosedived to between .25 and .50%. Earning that little is almost like stuffing cash in a shoe box under the bed.

The good news is that savings accounts are a safe and trusted way to save. Banks are guaranteed by the Federal Deposit Insurance Corp. and credit unions are guaranteed by the National Credit Union Federation, so even if the institution fails, savings are protected up to $250,000.

A large negative of using a savings account to save for college is that it can count toward a parent’s or student’s assets, which can lower the amount of financial aid a student receives. The interest rate is also lower than with accounts geared specifically toward college savings.

There’s also the temptation factor – it’s easy to withdraw money if the roof springs a leak. It helps to have the money available, but best growth happens if the account is left untouched until that first college tuition bill arrives.

Pros of a Regular Savings Account:

• Ease of setup and use.
• The money is safe and secure.
• You can use the money how you choose. This matters if college is not for your child; some college accounts can only be used for education.

Cons of a Regular Savings Account:

• No tax benefits. Unlike certain education savings accounts, there are no tax breaks in a savings account.
• Interest rates. Typically the interest on savings will not match or even come close to what an investment account can earn.
• Slower growth. While the account is secure, it might not grow as fast an account with market investments.

2. 529 College Savings Plan

A 529 plan is one of the better steps the federal government took toward helping people pay for college.

With a 529 plan, money that has already been taxed (i.e. part of your take-home pay) is invested through plans set up by states. The account should grow over time, and when the child is in college, money is withdrawn untaxed to pay for college costs.

That’s right, the 529 earnings are untaxed when used for education.

The money can only be used for specific educational purposes for the student listed as a beneficiary. Most plans allow those besides the person who has set up the account – see grandparents – to contribute.

While the details for 529 plans vary slightly from state-to-state, they are an excellent way to save money for tuition, room and board as well as books, fees and  supplies (think laptop). However, if you use the money for anything other than education, it will be taxed, and you will be charged a 10% penalty.

Starting in 2024, any money left after college is paid for can be moved to the beneficiary’s Roth IRA, though there are lifetime limits and rules on which contributions can be moved (those made in the previous five years cannot be moved).

Pros of a 529 plan:

• Earnings are not taxed as long as the money is used for defined educational purposes.
• The money can be used at any accredited college, including two-year, four-year, and graduate school (like Law School).
• The money also can be used for technical schools or even a culinary school, a big help if the offspring prefers a non-traditional college approach.
• If the original beneficiary does not use the money, the beneficiary can be changed.
• The money can be rolled into an ABLE account that covers expenses for disabled children and young adults.
• Anyone, not just a parent, can open an account for a child’s education.
• If a grandparent sets up an account, it is not reported on the FAFSA form that determines student aid (though it may be considered on the College Scholarship Service Profile).
• Only a fraction of a parent’s assets count against financial aid. Student-owned accounts don’t count at all against financial aid.

Cons of a 529 plan:

• The money is subject to the stock market. If the market gains, the money should grow. If the market tanks, the value could go down.
• Some states charge state income and capital gains taxes on earnings.
• Taxes and the penalty apply if the money is not used for education.
• Withdrawals from accounts owned by someone other than the student or parent have to be added back to the student’s income on the following year’s financial aid form and can reduce financial aid eligibility by as much as 50% of the amount of the distribution.
• Determining how much to fund can be a guessing game and requires savvy planning. If a student pursues a post-graduate degree that “too much” will be dispensed in a hurry.

3. Education IRA or Education Savings Account (ESA)

Education Savings Accounts (ESA) and Education Savings IRAs allow a maximum investment of $2,000 per child a year, after taxes. There are income limits to qualify for this account: Those who make $110,000 a year ($220,000 filing jointly) are not eligible. The contribution limit is reduced if a parent’s modified gross adjusted income is between $95,000 (or $190,000 for those filing jointly) and $110,000 ($220,000).

Compare that to a 529, which in 2023 allowed $17,000 annually to be invested.

ESA accounts work especially well for those who start when the child is born or is very young. If the $2,000 maximum is put in the account every year until the child goes to college, the amount invested will be $36,000, and the account will have earned more interest than a regular savings account.

Withdrawals are tax-free.

Pros of Education IRAs and ESAs:

• Earnings are tax free.
• There are a wider range of eligible uses (such as tutoring and uniforms) than with 529 plans.
• It’s a relatively painless way to save money for college long-term.

Cons of Education IRAs and ESAs:

• Those above the income limit have a lower yearly cap or are not eligible.
• Those who are below the income limit can only contribute $2,000 a year.
• The amount must be used by the beneficiary by age 30.

4. Roth IRA

If you’re already saving for retirement with a Roth IRA, you could add a little to save for college.

If money is withdrawn for education before the owner is 59 1/2, there is no penalty. However, earnings are taxed; earnings are not taxed in a 529.

Pros of Using a Roth IRA:

• Flexibility. Money does not have to be used for college tuition.
• Earnings can be withdrawn penalty-free – though taxes still have to be paid – if the money is used for higher education for the accountholder, their children, or their grandchildren.

Cons of using a Roth IRA:

• Like a 529, the value of the Roth varies with the stock market.
• Once the money is withdrawn, it counts against income and can reduce financial aid.
• Using the money for education can reduce retirement savings.
• Other relatives or friends can’t contribute the way they can to a 529 plan.
• There are limits to how much can be invested in the Roth annually.

5. UTMA or UGMA Custodial Accounts

Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) accounts are pretty much what they sound like.

Money is saved for the potential college student until he or she is 18 under UGMA and 21 under UTMA, then it goes to them. Once the student gets the money, there are no restrictions on how they spend it.

Both accounts can hold cash, stocks, mutual funds, and other assets; UTMAs can also hold real estate.

Pros of UTMA/UGMA:

• There is no limit to how much can be invested.
• Money can be used for anything, not just specified college expenses.
• There are tax benefits, including the value of the account being removed from the investor’s gross estate.

Cons of UTMA/UGMA:

• The beneficiary doesn’t have to use it for college, so if the parent saved in hopes of paying for college, your child may decide a new car is preferable.
• The beneficiary can’t be changed once he or she is designated.

6. U.S. Savings Bonds

U.S. Savings Bonds are government bonds that are bought at 50% of their worth, then redeemed 30 years later for the full amount.

The interest on bonds is free of state and local taxes, and federal taxes are deferred. With Series EE and I bonds bought after 1989, there are also no federal taxes if the money is being used for higher education expenses and the owner meets income requirements.

Pros of U.S. Savings Bonds:

• They’re tax-free if bought after 1989 and used for qualified higher education expenses.
• They’re secure, with a guarantee that the money will be there when they’re cashed in.

Cons of U.S. Savings Bonds:

• The return is low, though it is very low risk.
• The maximum investment is $10,000 a year, per owner and type of bond.
• If bond proceeds are not spent on tuition and fees, any interest earned is taxed.
• The interest exclusion phases out for incomes between $137,800 and $167,800 (in 2023) for married couples filing jointly or at $106,850 for individuals.
• In general, a savings bond will not earn as much as an investment-based account.

7. Invest in a Mutual Fund

Mutual funds are a good way to invest for long-term savings, and there is no limit to how much can be saved. With thousands of funds available, there are also a lot of options and chances for good return on investment. That said, they come with more cost than some education-specific savings plans do.

Pros of Using Mutual Funds:

• The money can be spent wherever it’s needed.
• There’s no limit to how much can be invested, and no restrictions on when it can be withdrawn.
• There are more than 7,000 mutual funds available, so finding an option with a high return is good.

Cons of Using Mutual Funds:

• Earnings are subject to annual income taxes.
• Capital gains are taxed when shares are sold.
• If owned by a parent, they’ll reduce financial aid eligibility by up to 5.64% of the account value, which grows to 20% if owned by the student.

8. Educational Trust Fund

A trust fund is an account set up by parents and then handed over to the child when they reach a certain age. The person who sets up the trust determines what the money goes to and how it’s paid out, so it can be as specific or general as the parent wants it to be.

Pros of an Education Trust Fund:

• There is more flexibility for using the money than with other education-specific funds.
• The person who sets up the fund can transfer assets and minimize their estate taxes.
• There’s no limit to how much money the fund can hold.

Cons of an Education Trust Fund

• The beneficiary may have to pay taxes on trust fund earnings.
• It can have an impact on the amount of financial aid awarded.

9. Coverdell ESA

A Coverdell Education Savings Account (ESA) is an education-savings account for a minor with special needs.

The ESA offers tax-free earnings provided the money is used for qualified education purposes but has eligibility restrictions and contribution limits of $2,000 per year from all sources. Married couples earning less than $220,000 or individuals earning less than $110,000 can contribute.

Pros of Using Coverdell ESA:

• Earnings are not taxed.
• The account can be transferred to another beneficiary if the original one does not use all the money.
• Money can be used for those in K-12 schools, but the limit of withdrawal is $10,000.

Cons of Using Coverdell ESA:

• The income limits mean not everyone can set up an ESA.
• There is a limit to how much can be withdrawn at a time.
• The maximum investment of $2,000 per year limits total growth.
• Withdrawals must be complete by the time the beneficiary is 30.

10. Brokerage Accounts

Brokerage accounts are investment accounts that can hold stocks, bonds, mutual funds, or money market funds. They provide great flexibility without limits on the amount invested, and there are no withdrawal restrictions.

Because these accounts are basic investment accounts, they will be taxed annually on income earned in the account.

Pros of Using a Brokerage Account:

• The door is wide open for the type and kind of investment you choose. Basically you can create your own portfolio of stocks, bonds and/or mutual funds.
• Money can be used for any purpose. So if there is money left over after college, it can help with a down payment for a home.

Cons of Using a Brokerage Account:

• The account will be taxed, from the start.
• There are no benefits for state taxes or credits.

Consider Getting Professional Help to Pay for College

No matter where you are on the college savings journey even if you’re just now planning to have kids, it’s important to make sure you’re in a financial position to start saving. If you have credit card debt, you may want to consider credit counseling, which can help you create a budget to start putting money away for your child’s college education. A nonprofit credit counseling agency also could provide a debt management program, to reduce your debt and make saving easier.