Saving for college: What are your options?

Photo of a father who has researched college savings options for his sons and decided which option works best for his family financially.

Education is one of the largest expenses you’ll likely face in your lifetime—and generally one of the most worthwhile. However you choose to save for college, the sooner you start, the more growth potential your money may have—and the less likely you’ll feel the impact on your paycheck.

College savings options can have a lot of rules. Tax advantages vary. To learn more about the tax benefits for education, read this IRS publication.

Graphic of a thumbtack. Tip: If you’re a year or so away from sending a teen to college, read our financial checklist of what you can do between now and then.

6 college savings options

1. 529 college savings plan

A 529 plan is an investment account operated by a state or educational institution. It’s specifically designed to help people save for college.

  • Many states offer tax benefits to state residents for money contributed to a 529 plan. Withdrawals—including potential earnings—are free of federal taxes, if they’re used for qualified higher education expenses.
  • If one child chooses not to go to college, you can designate the funds for another child or even future grandchildren.
  • As the account owner, you have full control of the money. (However, if you’re not the parent of the dependent/beneficiary, any qualified distributions may show as the child’s income for FAFSA® purposes.)
  • There are no annual contribution limits for 529 plans. But money contributed above the annual gift exclusion amounts should be reported on federal taxes, and that amount counts against the “lifetime” gift tax exclusion. Gifts that are more than the exclusion amounts could trigger gift and penalty taxes. Discuss implications with your tax advisor.

Read up on your state's 529 college savings program, which may offer preferential tax treatment.

Who may like this option: Those who want money to be used specifically for education, who have multiple people contributing (parents, grandparents, others), and want the flexibility to change beneficiaries, if needed. 

Learn more: Read About 529 plans: Education savings with tax benefits. Then use one of these tools to compare 529 plans.

2. Roth IRAs for college savings

These are retirement savings accounts that may also be used to fund qualified higher education expenses.

  • Good news: Early withdrawal penalties are waived when Roth IRAs are used to pay for qualified post-secondary education costs. Taxes may still be due on the withdrawals of any potential earnings.
  • There are some rules to follow so you don’t trigger a tax liability. If you use certain methods to pay for education,* the 10% early withdrawal penalty is not waived if you take an early distribution to reimburse yourself.
  • You can still leave investment earnings in the account to be withdrawn tax-free after 5 years and reaching the age of 59½.
  • Your Roth IRA can be used for retirement if the funds aren’t needed for education. If your son doesn’t go to college or your daughter earns a nice, big scholarship that covers her costs, you still have options for the money.
  • Money in a Roth IRA doesn’t count as parental assets under the federal formula for student financial aid. (Some schools do use a different formula that may consider these funds, so check with the school to get the details.) Withdrawals of principal and interest are counted as income when applying for financial aid.

Who may like this option: Those who want to be able to use funds for education, keep the funds for retirement if there’s a change in educational plans, and are OK with a limit on contributions. Note: This option has an income limit, so it’s not for high earners.

Learn more: Find out more about using Roth IRAs and 529 plans for college savings.

3. Coverdell Education Savings Accounts (ESAs)

These accounts allow you to set aside a maximum of $2,000 (as of 2018) for qualified education expenses for someone you designate as the beneficiary.

  • While there are no tax advantages for contributions, beneficiaries can generally withdraw money—including potential earnings—free of federal taxes, if the funds are used for qualified education expenses for kindergarten through college.
  • Your ability to contribute is phased out as your adjusted gross income increases.
  • If the money in the account is owned by the parents, then 5.64% of the assets are counted against federal financial aid.
  • The beneficiary (the person the account is for) gains control of any balance at age 30. You can also change the beneficiary of the account.

Who may like this option: Those who want to use funds for college and/or K-12 education, are OK with the lower max contribution per year. 

Learn more: The IRS provides more information about these accounts. IRS publication 970 also contains a chapter about rules and tax treatment for Coverdell ESAs.

What are “qualified education expenses?”

Good question. The shorter answer: it varies by savings vehicle.

529 plans: Tuition, fees, books, computers and related equipment, supplies, special needs. Some room and board at eligible colleges and universities. Up to $10,000 in tuition expenses at private, public, and religious K-12 schools.

Roth IRA: Same as 529 plans.

Coverdell ESA: Tuition, fees, books, supplies, equipment, special needs. Room and board for students going to school at least half-time. Additional categories of K-12 expenses.

UGA/UTMA: No restrictions.

Education savings bonds: Tuition and fees.

Life insurance: No restrictions.

4. Uniform Transfers to Minors Act (UTMA) accounts for college savings

UTMA is legislation that offers a tax-effective way to transfer assets to minors without establishing a special trust.

  • Anyone can open an account or contribute—you don’t need to be the parent. Nearly all states have adopted the UTMA law.
  • The irrevocable “gift” is held in the child’s name, and can include almost any asset, even real estate.
  • You can’t control how the money is used once the child reaches the age when they gain ownership of the account, which is generally 18 to 21 years old, depending on the state.
  • Money held in UTMA/UGMA accounts is considered the student’s assets on the Free Application for Federal Student Aid (FAFSA®). That means colleges expect students to use up to 20% of their assets to pay for college.

Its close cousin, Uniform Gifts to Minors Act (UGMA), is similar but assets are limited to cash, securities, and insurance policies. This type of custodial account can be opened through a bank or brokerage. All states allow UGMA accounts.

Who may like this option: People who have a significant amount of money to contribute (though be aware of gift tax rules) and are OK with the funds being potentially used for something other than education.

5. Education Savings Bond programs

Also known as United States Savings Bonds, education bond programs include Series EE (issued after 1989) and Series I, and they’re all backed by the U. S. government.

  • These bonds offer a way to save for qualified education expenses for you, a spouse, or a dependent. They’re backed by the taxation of the Federal Government and interest may be tax exempt. However, tax advantages phase out over certain income limits.
  • Interest is usually exempt from state and local taxes.
  • Like other college savings options, there are specific rules regarding who purchases the bond, how funds are used, and how they’re reported to the IRS. It can be kind of complicated, so dig in and learn more.
  • The Bureau of Public Debt’s website contains the latest rates for Series EE and Series I savings bonds and explains how to buy directly from the federal government.
  • Generally, bonds have lower rates of return, which may not keep up with the cost of college inflation.

Who may like this option: Savers who want a lower risk investment.

Learn more: Read chapter 10 of IRS publication 970 to learn about rules and tax treatment.

6. Life insurance: an option to save for college

This may be an unexpected source of funding. If you have a life insurance policy on the child or parents that has a cash value, you may be able to access those funds to help cover college costs, depending on your policy.

  • The policy’s value isn’t counted as an asset when applying for federal financial aid. And the cash value can be used for anything (not just education).
  • Loans you take against the policy’s cash value are income tax-free, as long as the policy remains active. Be aware there are some limits to the amount of premium payments you can make to your policy to maintain the income tax-free status of withdrawals.
  • Premium payments you make to a life insurance policy are with after-tax money, but there are no taxes on the growth of the cash value. Cost and fees may be higher than your typical 529 or Coverdell, mainly due to the cost for your insurance coverage plus any policy charges and fees.

Who may like this option: Someone who needs protection for their family or business and a way to fund other expenses down the road (which could include college.)

Learn more: Watch this video, and then talk to a financial advisor to see if this is an option for you.

Next steps

* Examples include: Pell grants, employer-provided and veteran’s educational assistance, tax-free distributions from a Coverdell account, tax-free portions of scholarships and fellowships, and any other tax-free payment (other than a gift or inheritance) given as educational assistance.

Reference of checklist is not an exhaustive list of what you should do. It and this communication are provided as education only with the understanding that Principal® is not rendering legal, accounting, investment advice, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment, or accounting obligations and requirements.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Securities offered through Principal Securities, Inc., 800-547-7754, member SIPC and/or independent broker-dealers. Principal Life, and Principal Securities are members of the Principal Financial Group®, Des Moines, Iowa 50392.