College is back in session across the country, and students attending four-year public institutions are spending close to $18,000 on average this year for the privilege. Those who attend private four-year colleges could be shelling out more than $40,000 annually.
Those figures come from the College Board, which published data for average tuition and room and board for 2012-2013. If those numbers are causing you to sweat, it may be time to think about your college savings strategy. Fortunately, the government makes it easy to choose where to start stashing money.
Tax benefits for college savings
While there are many ways to save for college -- from savings accounts to money market accounts to certificates of deposit (CDs) -- prepaid tuition and 529 savings plans come with tax benefits that make them the first choice for many families.
"These plans are clearly the most advantageous and best from a tax standpoint," says Chip Cobb, senior vice president at Bryn Mawr Trust.
Both plans fall under Section 529 of the tax code and are generally sponsored by states. Prepaid plans lock in current tuition rates while 529 savings plans allow parents to save tax-deferred money in an investment account. Money from 529 plans can be used tax-free for qualified educational expenses. States may also offer their own tax deductions or credits for those investing in the plans.
Prepaid tuition vs. 529 savings plans
As for which plan is a better deal, Cobb notes there are several factors for parents to consider. The first is where their child intends to go to school. Prepaid plans typically only pay for in-state public schools while savings plans are more flexible.
"There are less restrictions on the savings plans, and they give [students] the ability to go to any school in the nation," says Cobb.
However, 529 savings plans do not have guaranteed returns and come with the risk that their gains may not outpace the rate at which higher education costs are increasing.
"We've experienced a significant inflation rate in education, and that is expected to continue," Cobb explains.
With prepaid plans locking in today's tuition rates, they may look like the best deal for those who are sure a state university is a good fit for their child.
Still, Cobb adds there is one more wrinkle for parents to consider: state budgets. With many state governments struggling to avoid budget deficits, there is a question regarding whether they will be able to meet all their future obligations, including the payout of prepaid tuition credits. While prepaid accounts are reliant on state funding, this isn't a concern with 529 savings plans since they are individual investment accounts.
Other college savings options
Prepaid tuition and 529 savings plans may be most popular, but they are not the only options available for college savings. Coverdell Education Savings Accounts and custodial accounts are other commonly used options.
Coverdell ESAs likely lost much of their luster when 529 savings plans were introduced. Compared to 529 options, Coverdell accounts offer relatively few benefits. Each beneficiary can only have $2,000 per year deposited into an ESA for them. In contrast, 529 plans can have contribution limits of up to $360,000, depending on the state.
One benefit of Coverdell ESAs compared to 529 plans is that the proceeds from the account can be used to pay tuition for elementary and secondary schools as well. While contributions to the education savings accounts are not tax deductible, the money grows tax free and is not subject to income tax when disbursed so long as it is used for qualified education expenses.
Custodial accounts are allowed under the Uniform Gift to Minors Act and the Uniform Transfer to Minors Act and referred to as UGMA and UTMA accounts respectively. They provide a way for an adult to transfer assets, such as securities, to a child.
Although they can be used for college savings, money in custodial accounts is available for any purpose, which means a student could spend the funds on something other than school once they take possession of them. In addition, the assets in a custodial account belong to a student, which means it could negatively impact their eligibility for some forms of financial aid. Coverdell ESAs and 529 plans, on the other hand, are assets of the account holder -- typically a parent -- rather than the student.
Looking at the big picture
While saving for college is important, Cobb stresses that parents need to be mindful of their own financial needs first.
"The very first conversation I have with parents is to tell them to focus on themselves first and the kids second," says Cobb. "They need to be in a good financial situation themselves."
Cobb explains that many parents are joining the sandwich generation and taking on the dual responsibilities of caring for kids as well as aging parents. Taking care of retirement and debt obligations should be a priority for these individuals.
That may mean paying off the credit cards, beefing up their savings account or opening an IRA before worrying about how Junior will pay for college 15 years from now.