College savings plans: Why an early start can pay off

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Graduation day may come sooner than you think.

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So, there’s a new baby in the family. Congratulations. Although college may be the last thing on your mind right now, it’s not too early to start thinking about saving for college.

Between diapers, day care, and sleepless nights, it’s easy to put college planning on the back burner. But an early start gives your savings more time to benefit from compounding.

College costs have outpaced inflation for decades. No one knows what college will cost in 18 years, but it’s safe to assume it’ll stay pricey. And who says you’ll stop at one child? Several tax-advantaged options can help families save for future education expenses, including 529 plans and Coverdell education savings accounts (ESAs).

Compounding is a phenomenon where earnings from your investments get added to your original investment pile, and those earnings then build upon themselves. The longer your money remains invested, the more time compounding has to work.

For example, if you start with $1,000, add $150 each month, and the account grows an average of 6% each year (tax-free in your 529), you’ll have nearly $60,000 in college funds 18 years from now. Want to see for yourself? Click the link to the compounding calculator to explore different scenarios. The more you contribute each month, the more compounding can work its magic.

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You can get an early start funding college through tax-advantaged savings plans. These plans, sometimes known as qualified tuition plans, are sponsored by states, state agencies, or educational institutions, and are authorized by Section 529 of the Internal Revenue Code.

There are two types of 529 plans: education savings plans and prepaid tuition plans. Both are sponsored by state governments:

Regardless of which state you live in, you can open an investment account that can be used to pay tuition, fees, and room and board. Withdrawals from education savings plan accounts can generally be used at any public or private U.S. and some non-U.S. colleges or universities, with no in-state limitations and minimal impact on potential financial aid eligibility.

Contributions to a 529 plan are considered gifts for federal tax purposes and are subject to annual IRS gift tax exclusion limits.

You can fund a 529 plan yourself and/or get help from grandparents and others. The savings grow tax-deferred, and there’s no tax when you withdraw, provided the money is used for qualified education expenses. Many states offer tax benefits for contributions to the plans, meaning you might be able to deduct your 529 contributions from state income tax.

The plans offer a range of mutual funds and exchange-traded funds (ETFs)—usually conservative ones that aim to limit the risks to your college savings. The investment mix tends to tilt toward more conservative fixed-income securities as college approaches, but there aren’t any guarantees against losses.

One other possible drawback of 529 savings plans is that they typically have fees and expenses that reduce your returns. There also can be penalties if you don’t use the money for education, or if you withdraw any cash early.

A prepaid tuition 529 plan lets you prepay your child’s future college education at current prices, but not all states have them.

Some states offering these plans allow you to purchase by semester, rather than pay for all four years at once. With others you can pay by “unit,” for instance, purchasing a certain number of units of the total cost, which you can redeem in the future. Grandparents and others can also chip in.

Prepaid plans, like 529 savings plans, allow the value of the education to grow tax free and are tax free when you withdraw the money, as long as it’s for education costs covered by the plan. If college costs increase 20% between the time you buy your plan and when your child begins college, that’s like making an investment with a 20% return—tax free. But there are drawbacks.

You can typically only buy prepaid 529 plans for colleges and universities in your own state. As of 2022, Massachusetts is the only state allowing new investment from nonresidents.

If you move or if your child wants to attend an out-of-state school, the plans have contingency options, but they might include a fee. And the dollar value your plan pays might not cover the costs of college in another state.

Unlike education savings plans, prepaid tuition plans typically cover only tuition and mandatory fees, not room and board.

You’re not limited to one type of 529 plan. Some families have one of each for the same child, using one type of plan for tuition and fees and the other for room and board.

If your child chooses not to attend college, gets a full scholarship, or attends a military school, you have options. Although the rules vary, most plans allow you to transfer the balance, without tax consequences, to another beneficiary (e.g., a sibling or other relative). You could redeem the funds, if you have no choice—but you’d owe taxes on the investments and growth, plus a 10% penalty.

Compared with a 529, a Coverdell ESA is a trust or custodial account that offers greater investment flexibility, including the ability to invest in individual stocks. Coverdell funds can also be used to pay for qualified K–12 expenses.

Like 529 plans, Coverdell earnings grow tax free, and withdrawals are tax free when used for qualified education expenses. But income and contribution limits apply. Total annual contributions are limited to $2,000. Contributions aren’t allowed once modified adjusted gross income exceeds $110,000 for single filers or $220,000 for married couples filing jointly.

You can have a Coverdell and a 529 plan at the same time.

Starting early can give your college savings more time to grow. Understanding the differences between 529 plans and Coverdell ESAs can help you choose the approach that best supports your education savings goals. If you’re unsure which option is right for your family, a financial advisor can help you evaluate your choices.