To save money to fund your children’s college education, you can open an Education Savings Account, take advantage of a 529 Plan, or invest in Series EE and I Savings Bonds. But how do these college savings plans work?

Accumulating assets in your name has very little negative impact on your child’s ability to qualify for federal financial aid. However, should you decide to accumulate money in your child’s name, approximately 35 percent of those assets will be deemed available to pay for college costs, and financial aid will be reduced accordingly. Keep most or all the money you save for your child’s college education in your own name if you expect your scholar to qualify for financial aid.

Education Savings Accounts

Anyone with income of less than $110,000 ($220,000 if married and filing jointly) may contribute up to $2,000 per year to a Coverdell Education Savings Account (ESA) for each child under the age of 18. If you make too much money to contribute yourself, that may be a great incentive for Grandma to contribute. You can even gift the money to Grandma to contribute on behalf of your child if you’re so inclined. Contributions aren’t tax deductible; however, the earnings grow tax-free and remain tax-free as long as you use them to pay for qualified education expenses, kind of like how a Roth IRA is used for retirement savings. You can contribute $2,000 to an ESA and still contribute additionally to a 529 plan (see the following section for details of 529 plans).

You can open an ESA with a bank, mutual fund company, or any other financial institution that offers traditional IRA accounts. A good first choice is investing with a low-cost, no-load (no commission) mutual fund company. However, as of this writing, some fund companies, such as Vanguard, aren’t allowing new accounts at this time because the rules may change.

  • T. Rowe Price: Offers target date retirement portfolios that can be excellent, low-cost, maintenance-free investment options for your ESA account. The initial minimum investment is $1,000, and subsequent investments can be for $100 or more.
  • Scottrade: A discount broker that has ESAs available. The minimum initial investment is $500. Through this discount brokerage account, you can invest the funds in a variety of mutual funds,exchange–traded funds, stocks, or bonds.

Education Savings Accounts are considered assets of the custodian, which is typically the parent, when determining financial aid eligibility. However, the accounts have a lot of benefits, such as tax-free earnings, that far outweigh the slight negative impact on financial aid qualification.

529 Plans

Section 529 qualified tuition savings plans have evolved into one of the most attractive college savings programs available today. Just like ESAs (see the preceding section), 529 plan assets accumulate tax-free, and if your child uses them for qualified education expenses, the withdrawals are tax-free, too.

The biggest difference between the ESA and 529 plans is the contribution limit. You can invest up to $100,000 or more into a 529 plan, and you have no limitation based on your income. Another key difference is that 529 plans are state-sponsored programs. If your state offers good 529 plans and you invest in one, you may be able to deduct all or a portion of your contributions on your state income tax return.

Visit the Saving for College website for outstanding information and resources about all 529 plans, and pay particular attention to the plans offered through your state. This website has a proprietary 5-Cap Rating system it uses to evaluate and rate all 529 plans offers. The site also allows you to perform side-by-side comparisons of any 529 plans that you may be interested in, based on criteria that are important to you.

529 Plans are considered assets of the parent when determining financial aid eligibility.

UTMA/UGMA (Uniform Transfer to Minors / Uniform Gifts to Minors)

With the 1986 tax law changes, the advantages of these accounts are minimal. These accounts are not tax-deferred or tax-free education savings plans, and they pale in comparison to the Section 529 and Education Savings Accounts now available.

Series EE and I Savings Bonds

You can purchase up to $30,000 (face amount) of either Series EE or Series I Savings Bonds per year. You can purchase savings bonds, which are issued by the U.S. government, through local banks or through Treasury Direct for as little as $25. Savings bonds may appeal to you if you’re looking for a very low-risk investment. As of this writing, the current yield on savings bonds is 1.1 percent per year. The interest rate on savings bonds changes semiannually based on the 10-year U.S. Treasury bond yield.

You receive no tax deduction for making this investment; however, the interest on these bonds is tax-free if you redeem the bonds to pay for qualified education expenses and your income doesn’t exceed the federal limitations in the year of redemption.