Even if college is just a year or two away, it is never too late to start saving and every dollar you save is a dollar less you’ll need to borrow.  There are many college savings vehicles available. Below is a summary of the most popular ways to save and invest:

Section 529 Plans- Prepaid

This is a college savings plan that guarantees increases in value at the same rate as college tuition. Prepaid tuition plans are operated by state governments, with the tuition guarantee based on an enrollment-weighted average of in-state public college tuition rates.

A prepaid tuition plan functions by purchasing units – each unit corresponds to a % of tuition or contracts – a specific number of years of tuition.  Anyone can contribute including grandparents, friends and family.  Prepaid 529 plans are great because they lock in tuition at the current rates (hedge against inflation).  There is no guaranteed admission. Contributions receive tax deferred growth and tax free withdrawals if funds are used for qualified higher education expenses (tuition, room and board, fees, books, supplies and equipment).  If the child dies or decides to not go to college, the plans can be transferred to another member of the family. This plan can also be used out-of state but is geared toward in state college attendance and the account owner or beneficiary must be a state resident when the account is opened.  If a student chooses to attend a different college, the parents are responsible for paying the difference between the average public state college and the college of choice.  Penalties and reductions in investment returns for non qualified withdrawals and cancellations exist.  Some colleges require contributions for a 10-year time period from the date of expected college entrance or high school graduation. The funds must be used by the time the beneficiary reaches age 30.

Section 529 Plan – Savings

Section 529 college savings plans are tax-exempt college savings vehicles with a low impact on need-based financial aid eligibility. Unlike prepaid tuition plans, there is no lock on tuition rates and no guarantee. Investments are subject to market conditions, and the savings may not be sufficient to cover all college costs. Section 529 college savings plans are considered assets of the account owner and not the beneficiary. Contributions receive tax deferred growth and tax free withdrawals if funds are used for qualified higher education expenses (tuition, room and board, fees, books, supplies and equipment). Investments should start aggressive and switch to more conservative strategy as college approaches.  No restrictions on choice of college, other than that it must be an accredited post-secondary institution. There is also no date by which funds must be used.  If you cancel and receive a refund you must pay federal income taxes on earnings, a 10% penalty and any nonqualified withdrawals are taxed as ordinary income to the account owner.  There may also be state and local income taxes and penalties as well as plan penalties.  However, you can change the beneficiary at any time to another family member.


Savings Bonds

Series EE and I are safe, low risk, modest return investments backed by the full faith of the US Government.  Bond owners must be at least 24 years old and are held to a $30,000 limit per year, per parent and per bond.  Detailed records must be maintained on educational expenses and bond information for tax purposes.  The bonds are issued at 50% of face value and are guaranteed to reach face value in 17 years.  Bonds are exempt from state and local income tax. They also receive federal income tax deferral until bonds are redeemed or reach maturity date (30 years) and used to pay for qualified higher education expenses.

Coverdell Education Savings Account (Education IRA)

Coverdell accounts are trusts created exclusively for the purpose of paying the qualified education expenses of the designated beneficiary of the trust. There is a $2,000 max per beneficiary from all sources per year and a donor income limitation. This asset is owned by parent or student and contributions can be accepted until age 18.  Funds must be used by age 30 or earnings will be taxed as ordinary income and a 10% penalty.  There is no federal or state income tax contribution deduction.  Earnings accumulate tax free and are exempt from federal income tax as long as funds are used for qualified higher education expenses.  Non-qualified withdrawals are taxed as ordinary income at donor’s rate and 10% tax penalty.  Funds can be rolled over to another family member or and another Coverdell account.  Moreover, the funds can be used to pay for elementary and secondary education tuition and fees.  The Hope or Lifetime Learning Credit and a qualified tuition plan can be coordinated to reduce qualified higher learning expenses.

Retirement Plans

Distributions from IRA/Roth IRA used for qualified education expenses for you, spouse or grandchildren are exempt from a 10% penalty but you still pay income tax.  If you’re over 59 ½ and had a Roth IRA for more than 5 years, the entire distribution is tax free.  Funds in a traditional IRA are sheltered from financial aid analysis in the current year but not the following year.

You can borrow up to half your vested balance in a 401k, 403b and 457 plan or $50,000, whichever is less.  Distributions must occur in year qualified expenses are paid.  The downside to borrowing from your retirement plan is that once the money is gone you cannot put it back. You will use after tax dollars to repay the loan and lose the benefit of a tax shelter as well as the money your retirement funds would have earned plus all the compounding.  The loan must be repaid in 5 years and if you can’t repay the balance it will be considered a taxable distribution with a 10% early withdrawal penalty. If you aren’t 55 or older, you may also incur state tax penalties.  If you quit, are fired or are laid off your loan may be due immediately.


Uniform Gift to Minors Act and Uniform Transfer to Minors Act allows transfer of securities (stocks, bonds mutual funds) or property from parent to minor child without services of an attorney or trustee.  The donor irrevocably gifts money to the trust.  The money belongs to the minor but is controlled by the custodian until age 18.  The income from the custodial account is reported on the child’s tax return at the child’s rate for which the parent is responsible for filing on behalf of the child.  The funds are not transferable to another beneficiary.  UGMA/UTMA’s are student assets and have a high impact on financial aid eligibility. If money is transferred to a 529 plan the guidelines of the UGMA or UTMA still apply – it is an irrevocable gift to the child.  If the child transfers the money back to the custodian and the IRS finds out and determines no gift was made – the custodian could owe back taxes and pay penalties.

Minor’s Trust

It is a separate legal entity established to hold gifts in trust for a child until the child reaches age 21. The trustee can spend the trust’s funds on college expenses for the child.  There are high set up and administrative costs (attorney).  It is considered a student asset (high impact) for financial aid purposes.  The trust no longer qualifies for the gift tax exclusion after the child turns 21.  Income from the trust is taxed at trust rates unless distributed to the child and becomes taxed at the child’s rate.

Qualifies for the gift tax exclusion if:

  • The property or income in the trust can be used for the benefit of the child prior to age 21
  • If the child dies before age 21, the trust becomes included in the child’s estate
  • All undistributed property and income must be distributed to the child on his/her 21st birthday
  • Gifts to the trust are irrevocable

Variable Universal Life

It is a combination of life insurance with a tax deferred investment account that provides tax-free access to the cash value of the policy.  There is no impact on financial aid analysis (not an asset) and no limits on the amounts you can invest.  The parent retains control over money and the child is protected with life insurance.  High expense and sale charges apply and the premiums are not tax deductible.  You can withdraw or borrow contributions tax-free without penalty.  You have the option of starting aggressive and switching to more conservative investment portfolio.  Investments have a great rate of return but there is a greater risk.  If your child does not go to college the money can be used for other purposes without tax consequences.

Home Equity

Proceeds from an equity line of credit do not count as income and the interest is tax deductible.  The interest rate on a home equity line of credit is higher than rates on federal education loans but lower than private education loans.  You may not qualify for a loan if you have lost your job or cannot show income to lenders.  The net market value of your primary residence is considered for financial aid if your child attends a private college that uses the institutional methodology.  The value of your primary residence is not an asset for colleges that use the federal methodology.