Updated: Sep 26, 2019
Paying for college requires planning, and planning means saving ahead of time. While you or your child can start setting aside money in a savings account, if you are in the United States you’ll want to seriously consider using a 529 College Savings Plan instead (If you live outside of the U.S., do some research to see if a similar account is available to you).
The 529 Plan is similar to a retirement plan, but created specifically for education. Like a Roth IRA, you contribute to a 529 Plan using after-tax dollars, but it is an investment that grows tax-free and can be withdrawn tax-free (provided the money is spent on qualified education expenses, like tuition, fees, room, and board, with some exceptions). 529s are state-sponsored plans, so many states even allow you to deduct all or a portion of your annual 529 Plan contributions when filing your taxes.
As a parent, you can be the owner of the 529 Plan but list your child as the beneficiary, giving you full control over how the money is spent. While only one child can be a beneficiary on a 529 Plan at a time, you can change the beneficiary at any time. So if money is left over when your eldest completes college or your daughter decides to join a convent, you can transfer the account to their younger sibling. However, if you expect to have multiple children in college at the same time (which is likely for large families), I suggest opening multiple accounts, one for each child. Anyone can contribute to a 529 plan, including parents, grandparents, friends, and the child. There is also no annual contribution limit, although if any non-parent individual contributes over $15,000 (the 2019 threshold) in a single year, that additional amount is subject to a gift tax. Another great thing to note is that with the new tax law passed in 2018, 529s can be used to fund K-12 education as well (although homeschooling is expressly excluded). However, your child can use these funds to pay for community college courses while still in high school that will transfer to their college of choice.
While the 529 Plan has a lot of great advantages, there are limitations. Balances cannot exceed the expected cost of education expenses. This ceiling varies by state, but it’s typically over $300,000. Also, like I mentioned above, the money can only be used for a qualified education expense, otherwise it is subject to taxes and a penalty. If over-funding the 529 Plan worries you, remember that you can avoid the penalty by changing beneficiaries so that another member of the family can use the remaining money. There is also an exception so that if the child/beneficiary receives a scholarship, you can withdraw funds from the 529 Plan equal to the scholarship award without being penalized, although taxes will be owed on the earnings. There are a lot of caveats with the 529 Plan, so check with a financial advisor to learn more about how a 529 Plan impacts your unique situation. However, for many people it provides many advantages over a savings account.
Now that you are on your way to saving for college, check out Drastically Cut the Cost of College with these Tips and You May Be Paying for College the Wrong Way (coming soon).