It's one of the most common questions I get -- "What's the best way to save for college?". Or the other one that's popular nowadays -- "Is a 529 plan the best way to save for college?"
So I thought I'd address that here, by listing 10 of the most common options parents of college-bound children have for saving and paying for college, and the pros and cons that go along with each one.
The point here is to know what your options are. And know the answers to the following questions when determining the best college savings or funding account for you to use -- questions like:
* Is the money liquid for any purpose?
* What if an opportunity or emergency comes up where i need the money?
* Does the account allow for flexibility if circumstances in my life change?
* How does it count against me for financial aid?
* What happens if the stock market crashes? How will it affect my plan?
* Is my money guaranteed to be there when I need it to be and guaranteed to grow each year?
* Will my money earn a competitive rate of return?
* Are there any tax advantages to my plan?
So without further ado, let's get started...
1. Non-Qualified Mutual Funds and Stocks
Pros: Unlimited upside gains. Can be sold at any time. Can contribute as desired.
Cons: No guarantees. Unlimited downside losses. Interest and dividends are taxed each year. Distributed gains are taxed each year. Unrealized growth is taxed when sold. Depending on how funds are registered, they can count against the student's potential aid eligibility anywhere from 5.64 percent to 20 percent. Account could go down by 30 percent or more the year you need the money to pay for college.
2. 529 College Savings Plans
Pros: Tax deferred growth. Tax-free withdrawals for qualified educational expenses. Unlimited upside potential on underlying investments, assuming investment in the stock market. Certain state tax deductions. Flexible contributions.
Cons: Unlimited downside potential on underlying investments, assuming investment in the stock market. Even some bond funds have lost upwards of 35 percent or more in certain 529 accounts. Counts against the student's potential aid eligibility (depending on who owns the account and what types of schools you are looking at will determine exactly how it counts against you) Potentially high internal fees depending on the plan selected. Government definitions of "qualified expenses" can limit your use of the money -- especially if your child ends up getting a scholarship, doesn't end up going to college, etc...
3. Maximum Funded Permanent Cash Value Life Insurance (and when I say 'maximum funded', I'm referring to overfunding a policy so that its primary focus is on accelerating significant cash value growth vs. focusing on getting the highest death benefit)
Pros: Guarantees of the principal. Consistent, steady returns. You know the money will be there when you need it to be -- regardless of the stock market. Contractually guaranteed to go up each year. Growth is usually better than any fixed bank savings account or CD. Cash value is not included in the financial aid formulas, thereby allowing for potentially more need-based financial aid. Tax-deferred growth. Potentially tax-free withdrawals. Includes a self-completing feature that automatically completes the funding of the plan in the event of your death and possibly in the event of disability (depending on the options you select). Forced savings. State guaranty fund (similar to FDIC insurance but on the state level). Can 'set it and forget it'.
Cons: Slower growth potential than stocks or real estate in an 'up' market. Need to be insurable (you can't just open a life insurance policy like this -- you need to apply and be approved and have an insurable interest). Lots of sub-par products out there that work best for the agent and not for the client (you need to work with an agent that structures these policies correctly or else you end up with something that won't work very well). Takes some time to build up gains depending on the product selected and how it's structured.
4. Certificates of Deposit (CDs)
Pros: FDIC insures principal and interest up to $250,000. Guaranteed interest rates.
Cons: Possible penalties for withdrawing before maturity. Counted in the financial aid formula; depending on how the CDs are registered, they can count against the student at the rate of 5.64 to 20 percent. Slow growth.
5. Money Market and Bank Savings Accounts (I lumped these two together since they have virtually all the same features.)
Pros: FDIC insures principal and interest up to $250,000. Typically have guaranteed minimum interest rates. No penalties for withdrawing for college or any other reason.
Cons: Interest is usually low and probably doesn't keep pace with inflation. With problems in the banking industry, FDIC insurance could be slow to respond to claims approaching $250,000. The asset is counted in the financial aid formula; depending on how the account is registered, it can count against the student at a rate of 5.64% to 20%.
6. Non-Qualified Fixed Annuities
Pros: Principal and interest rate are guaranteed. Growth is usually higher than bank savings account interest and CDs. Value is not counted in the FAFSA financial aid formulas, thereby allowing for potentially more financial aid. Growth is tax-deferred.
Cons: Possible penalties for withdrawals before maturity. Income taxes are owed on gain and growth distributions. Typically limited to withdrawals of 10% per year. Larger surrender charges on certain annuities (so again, you need to shop around for an agent that has your best interests in mind).
7. Tax-Qualified Retirement Accounts (401k, IRA, etc...)
Pros: Unlimited upside potential, assuming investment in the stock market. Value is not counted in financial aid formulas, thereby allowing for potentially more financial aid.
Cons: Unlimited downside potential, assuming investment in the stock market. Penalties and tax consequences for withdrawals before age 59½. Limited contributions each year. Contributions to such accounts are added back into the financial aid formula as part of available income. Bad financial planning to take from retirement accounts to pay for college.
8. Treasury Bills
Pros: Considered by many to be the safest place in the world to park money. Backed by the U.S. Government.
Cons: Very low current interest rates. Penalties for withdrawing or selling before maturity. Counted in the financial aid formula. No guarantees on principal if sold before maturity.
9. Municipal Bonds, Including Tax-Free Municipal Bonds and Bond Mutual Funds
Pros: Guaranteed interest rates. Can be tax-free. Well-rated bonds can be relatively safe.
Cons: No guarantees on the principal. Can be taxed. Included in financial aid formula. There can be penalties for redeeming before maturity.
10. UTMA/UGMA Accounts (Uniform Transfers To Minors Act/Uniform Gifts To Minors Act)
Pros: Unlimited upside gain. Taxed at child's tax rates.
Cons: No guarantees on the principal. Unlimited downside losses. Significant impact on financial aid eligibility.
There you have it -- 10 of the most common ways people save for college and some of the biggest pro's and con's of each. Now here's the legal disclaimer: please do not take this as specific financial advice -- you need to consult with a professional before you make any decisions as to what's best for your specific situation. This is merely to provide you with a general overview of how different accounts work and what options exist so that you never again have to ask "What's the best way to save for college?" or "Is a 529 Plan the best way to save for college".