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Parenting doesn’t stop when a child becomes an adult; in some ways, adult children are even more expensive, especially when it comes to paying for college. But a college fund can help.

Usually, parents start college savings plans for their children when they are young. Starting a fund early in your child’s life can lessen or eliminate their need for student loans and can give them a head start toward a healthy financial future.

According to the Education Data Initiative, when you factor in student loan interest and foregone income during college, the ultimate cost of a bachelor’s degree can be more than half a million dollars. Most families don’t have that amount of money just lying around; if you do, this article likely isn’t for you.

Getting started on a college fund can feel overwhelming, but it doesn’t have to be. In the article below, I will help you pick an investment account, understand the federal and state tax advantages or disadvantages, decide what to invest in, and more. 

The earlier you start a college savings plan, the more time the account has to grow, so let’s get started.

Step 1: Determine the Best College Plan for You

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Obviously, you can’t do anything with a college fund until you’ve selected one. To do that, you’re going to have to understand more about the ins and outs of different college savings plans.

Here’s a list of some of the most important aspects of college plans, which I’ll go into more depth about as I run you through the rest of the steps:

  • Contribution limits: Some college investment accounts have contribution limits, while others have no limits. For those with a limit, the contribution limit varies by account type.
  • Investment choices: Depending on the college saving plan, you may be limited to just a couple of investment options, or you may be able to invest in almost anything.
  • Federal income tax benefits: Several college savings plans come with federal income tax benefits. Other accounts offer no tax advantages and are subject to ordinary taxes.
  • State tax benefits: Most states offer tax breaks on saving for college if the savings plan is an account designated specifically for education. These are commonly known as 529 plans, named for the part of the federal tax code that established them, and almost every state administers one. However, not all accounts qualify for these benefits.
  • Financial aid considerations: Some college savings accounts affect financial aid eligibility much more than others do. If your child is likely to need financial aid, it’s important to pick an account that doesn’t seriously limit their eligibility.

Related: 6 Best Investing Apps for College Students to Start Investing

Step 2: Contribute to the Account

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Contribution Limits

While it would be amazing to sock away as much money as you could into a college savings fund, many account types do have annual limits.

529 plans

A 529 college savings plan can refer to either an investment account or a prepaid tuition plan run by a state government. It’s much more common to have an investment plan than a prepaid tuition plan, so this is the type of 529 college savings plan highlighted in this piece.

Technically, there is no limit on how much you can contribute to a 529 plan. However, when you contribute to someone’s 529 plan, that money is considered a gift for federal gift tax purposes and may have federal gift tax consequences. For 2023, the annual gift tax exclusion is $17,000.

YATI Tax Tip: An individual can contribute five years’ worth of gifts to a child’s 529 plan in one year without having to pay gift tax or have the excess counted towards her lifetime exclusion or estate tax exemption (though it still needs to be reported to the IRS).

Coverdell education savings accounts

Coverdell education savings accounts (ESAs) are a type of education savings plan created by the U.S. government to help people pay for their children’s higher education costs. A beneficiary can have more than one ESA, but the contribution limit for all accounts combined is $2,000.

Unlike 529 plans, only individuals whose income is below a certain threshold can contribute to a Coverdell account. For 2023, only people whose adjusted gross income does not exceed $95,000 for single filers and $190,000 for married joint filers can contribute the full $2,000 annual limit to an ESA.

Roth IRAs

A Roth IRA is a type of individual retirement account, but as we explain later, it can also be used to pay for college-related expenses. Roths have two different contribution limits that cannot be exceeded. Users can’t go over either limit, meaning the lower limit should be followed. First, for a Roth IRA set up in the minor child’s name, annual contributions can’t exceed the child’s earned income that year. For example, if the child earned $2,500 from an after-school job that tax year, that’s the maximum amount his parents can contribute to the account.

No matter how much the child earns in a year, he (or his parents or other adult benefactors) also cannot contribute more than the annual contribution limits for a Roth IRA. For 2023, that maximum is $6,500. Let’s say a hard-working teen earned $8,000 in 2023. The most that he or his parents could add to his Roth IRA that year would still be $6,500.

Custodial accounts

Custodial accounts, in which a parent or other guardian funds a savings account or investments for a minor child, have no maximum contribution limit. The funds can be used to pay for higher education expenses, including costs that 529 or ESA plans can’t cover.

However, contributors are still bound by the annual gift tax rules. Also, earnings in the custodial account can trigger the “kiddie tax” if they exceed a certain annual threshold, which creates tax liabilities for the minor child. (More on this later.) Additionally, funds in a custodial account earmarked for college costs have a greater impact on the child’s eligibility for financial aid than do savings in a dedicated college plan like a 529.

Finally, while the money in a custodial account can be used to pay for college and related costs, the child is not obligated to follow through on that intention once they reach a certain age (which varies by state). At that point, the beneficiary can legally use the money for any purpose, without the approval of the person who funded the account for her.

Taxable brokerage accounts

There is no annual contribution limit for a taxable brokerage account. You can contribute as much as you are able, and use any or all of the account’s funds to pay for a child’s college expenses when the time comes. But you won’t derive any tax breaks this way, and the amount of money you have in a traditional brokerage account will impact how much financial aid your child is eligible for.

Related: 16 Best Brokerage Account Bonuses, Promotions + Deals

Taxes on Contributions

Taxation on contributions differs from one college fund to the next, too.

529 plans

A 529 college savings plan is funded with after-tax money. There are no federal tax incentives. The good news is that there are usually state tax advantages.

Most jurisdictions offer a state income tax deduction or credit, provided you’re participating in your state’s plan. Only a few states don’t provide any state income tax breaks for contributions to a 529 plan.

Note that you may not get a full tax break, though. Your state may limit the amount that qualifies for a state income tax or deduction. Additionally, you may only be able to withdraw money free of tax for funds used towards college education costs and not K-12 expenses, depending on your state’s rules.

Coverdell education savings accounts

Coverdell ESAs are also funded with after-tax dollars. Contributions to this type of education savings plan are not deductible.

Roth IRAs

Roth IRAs are funded with after-tax dollars, so participants have already been taxed on contributions. You do not get a federal tax deduction. The contributions you make can be withdrawn at any time without needing to pay any taxes. Tax treatment of the earnings work differently and are explained in detail below.

Custodial accounts

Custodial accounts are funded with after-tax dollars. Usually, parents or other family members gift money to the account. Once money hits the account, it legally belongs to the beneficiary.

A person can contribute up to $17,000 per year ($34,000 per couple) in gifts to a minor child’s account without tax consequences. Any amount over this threshold triggers federal gift tax rules.

Taxable brokerage accounts

Taxable brokerage accounts are funded with after-tax money, so users have already paid state and federal income taxes on the contributions. These accounts offer no tax deductions.

Related: Roth IRA vs. 529 Plan: Which Is Better For College Savings?

Step 3: Invest Within the College Fund

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Investment Choices

Your college fund’s investment options vary depending on the account type. Some investment accounts allow just about any type of investment, while others are much more limited. Stocks, mutual funds, and exchange-traded funds (ETFs) are among the best investment choices you can make for a college fund.

529 plans

Unfortunately, 529 college savings plans have pre-set, limited investment options. Often, there is an option to choose an age-based portfolio that adjusts as the child gets closer to college age, similar to target-date funds often found in retirement plans.

Users are not allowed to switch investments very often. Currently, the law only allows an account holder to change the investment option up to twice per year or if the beneficiary changes.

Coverdell education savings accounts

Coverdell ESAs let users make their own investment decisions to meet their investment objectives. They can usually choose to invest in any combination of individual stocks, ETFs, traditional funds, and more.

Roth IRAs

Roth IRAs let users invest in stocks, bonds, ETFs, mutual funds, CDs, money market funds, annuities, and more. Those with a self-directed IRA can even invest in more exotic, alternative investments, such as cryptocurrency and real estate. However, users can’t invest in life insurance.

Custodial accounts

Money in custodial accounts can be invested in stocks, bonds, funds, annuities, and other assets. Rules on investment options, tax treatment and more vary depending on the account type.

Taxable brokerage accounts

The types of assets you can hold in a taxable brokerage account vary by brokerage firm. Most brokerages allow you to invest in stocks, bonds, ETFs, mutual funds, and options. Some may allow commodities, cryptocurrency, and other alternative investments.

Related: How Old Do You Have to Be to Invest in Stocks? [Age to Invest]

Taxes on Growth in the Account

Depending on the account type, you might owe taxes from year to year on things like capital gains or income distributions.

529 plans

The earnings from a 529 plan grow free of tax and remain that way as long as withdrawals are used toward qualified education expenses.

Coverdell education savings accounts

The earnings a Coverdell ESA generates grow without owing taxes until they are withdrawn. The earnings remain untaxed as long as they are used toward qualified education expenses.

Roth IRAs

Earnings in a Roth IRA grow tax-free. But, how those earnings are taxed when withdrawn depends on the account beneficiary’s age and how the withdrawals are used. (More on that in the next section.)

Custodial accounts

Custodial accounts are subject to kiddie tax rules. There are three stages for how earnings in a custodial account are taxed:

  1. The first $1,250 of unearned income is free from taxes.
  2. The next $1,250 is taxed at the child’s rate.
  3. Anything over $2,500 is taxed at the parents’ rate.

Taxable brokerage accounts

Any earned income in a taxable brokerage account is taxed the year the income is realized. You’ll owe capital gains taxes if you sell a stock or fund for a profit, and you’ll also owe taxes on income earned from distributions such as bond interest and stock dividends.

Related: 5 Best Investment Accounts for Kids [Child Investment Plans]

Step 4: Withdrawing the Funds

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Qualified Education Expenses

Many accounts allow tax-free withdrawals if the money is used towards qualified education expenses. Qualified education expenses include college tuition & fees, K-12 tuition, room and board (with at least half-time college enrollment), books, computers, and more. It doesn’t include general expenses like health insurance or transportation.

529 plans

Anyone with a 529 plan can withdraw any amount of money at any time to use towards qualified education expenses. Depending on what institution the account is through, you may be able to request a withdrawal online. Alternatively, you might need to call the plan administrator or submit a withdrawal request form.

Coverdell education savings accounts

Beneficiaries can take untaxed withdrawals at any time to pay for qualified education expenses. As long as distributions don’t exceed beneficiaries’ qualified education expenses, no taxes need to be paid on earnings.

Any unused money in the account must be distributed within 30 days after the designated beneficiary turns 30 years old. There is an exception if the beneficiary has special needs. In the tragic event that a beneficiary dies before age 30, any remaining funds must be distributed within 30 days after the date of death.

Roth IRAs

Although this is a retirement account, users are allowed to withdraw contributions to the plan at any time because they were already taxed on that money. Earnings can be withdrawn before retirement age without penalty if the funds are used for qualified education expenses, but the account owner must still pay federal income taxes on those withdrawals.

Custodial accounts

Funds can be withdrawn from a custodial account at any time. However, the funds must be used in a way that benefits the beneficiary. Parents can’t withdraw money from their child’s account to spend on their own wants or needs. Distributions are never legally required.

Taxable brokerage accounts

You can withdraw money from a taxable brokerage account at any time for any reason.

Related: Student Loan Interest Deduction: How Much, Eligibility + More

Penalties + Taxes on Withdrawals

College funds have varying rules as it pertains to whether you’ll pay tax (and even penalties) upon withdrawing the money from your account.

529 plans

Any 529 plan distributions used toward qualified education expenses aren’t subject to income taxes. However, distributions used for non-education-related expenses trigger taxes on any earnings withdrawn and face an additional 10% penalty.

There are a few exceptions where the penalty is waived, including if the beneficiary experiences any of the following:

  • Dies or develops a disability
  • Earns a tax-free scholarship or fellowship grant
  • Attends a U.S. military academy
  • Receives employer-provided educational assistance, veterans’ educational assistance, or other tax-free educational assistance payments

Coverdell education savings accounts

Any distributions from a Coverdell ESA not used for qualified educational expenses are subject to a 10% penalty and ordinary income taxes on any part of the withdrawals attributed to your gains (also known as any earnings withdrawals).

Roth IRAs

Roth IRA money withdrawn during retirement faces no taxes or penalties. Usually, any earnings the account generates that are withdrawn prior to age 59 and a half are subject to taxes and a 10% penalty.

However—and this is key to college savings planning—funds used by a participant before they reach retirement age for qualified education expenses are an exception. You do have to pay taxes on any early earnings withdrawals (withdrawals of contributions are never subject to taxes), but the 10% penalty is waived, as long as the account has been open for at least five years.

Custodial accounts

There are no penalties for custodial account withdrawals as long as the money is used in a way that benefits the minor for whom the account was established. As previously mentioned, earnings are subject to the kiddie tax.

Taxable brokerage accounts

There are no penalties for making withdrawals from taxable brokerage accounts. You are taxed for earned income in the year the income is realized, whether you keep that money in the account or withdraw it.

Related: 11 Education Tax Credits and Deductions for 2023

What Happens to Funds if Your Child Doesn’t Go to College?

Obviously, as a parent investing in a college fund, your hope is that your child goes off to college and spends the money in the account. But it doesn’t always work out like that, so you should be aware of the potential consequences should your child not go to college.

529 plans

College isn’t for everyone. Rather than pursue higher education, your child may choose to immediately enter the workforce, travel the world, run away and join a circus, etc.

In the event a child doesn’t go to college or only uses a fraction of the 529 plan funds, you have several options for what to do with the money in the 529 plan.

One option is to simply wait. A 529 plan doesn’t have any specific withdrawal deadline. If you expect your child to start college after a gap year in Europe or that he’ll soon discover the circus life is too chaotic, you can wait a bit and see if he ends up wanting to use the money for college after all.

Another option is to change the beneficiary of the 529 plan to a qualifying family member. The most popular option is to transfer it to a sibling of the original beneficiary, but many other family members qualify, as well. For example, you might let a niece use it towards her K-12 private school tuition (if your state allows K-12 expenses).

If a family member has a 529 ABLE account, which is for eligible people with disabilities, funds can be transferred to that account, as well. For this option, you need to be careful not to exceed the ABLE account’s annual contribution limit.

Recent legislation provides another option that wasn’t previously available. Beginning in 2024, the beneficiary can transfer up to $35,000 of unused 529 plan money into a Roth IRA in their name. To qualify, the 529 plan must have been open for a minimum of 15 years. Note that any transfers can’t exceed the annual Roth IRA contribution limit, which is currently $6,500. In other words, to contribute the maximum $35,000, the beneficiary will have to move the money in chunks each year, until they reach $35,000.

The final option should be your last resort, if possible. The 529 plan money can be withdrawn and used for non-qualified expenses. However, that means the earnings would be considered taxable income (and thus be taxed) and trigger a 10% penalty unless the beneficiary meets an exception to the 10% penalty listed above.

Coverdell education savings accounts

You can change the beneficiary of a Coverdell ESA to a qualifying family member if the original beneficiary doesn’t go to college or doesn’t use up all of the funds in the account. Note that the beneficiary change has to be initiated before the original beneficiary turns age 30, and the new beneficiary must be under age 30.

Roth IRAs

Any funds in a Roth IRA not used for college can continue to benefit from untaxed growth. Ideally, the money isn’t withdrawn until retirement, at which point no taxes on earnings are owed and no penalty is charged.

In addition to education expenses, there are a few other exceptions where earnings in a Roth can be withdrawn without penalty prior to retirement. For example, up to $10,000 of earnings can be used toward the purchase of the beneficiary’s first home without owing the early withdrawal penalty. If the account is more than five years old, the beneficiary can use that $10,000 limit on the purchase of a first home without owing tax on the earnings, either.

Custodial accounts

Custodial account usage isn’t limited to educational expenses. The funds can be used in any way that benefits the minor.

Taxable brokerage accounts

If a child doesn’t attend college, you can simply use that money towards another expense. Taxable money in a brokerage account doesn’t need to be used toward education.

Related: SEP IRA vs. Roth IRA: What’s the Difference?

Starting a College Fund: FAQs

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What if I can’t afford monthly contributions?

Higher education can be very expensive, especially if a child wants to attend a private college. Parents should make an education savings plan based on how much they can save for a child’s future college expenses.

Unfortunately, not every family can afford monthly contributions. Those who can’t will have to rely more heavily on scholarship funds, federal student aid, and possibly private loans. Whoever is listed on a student loan is responsible for making those student loan repayments.

As interest accrues, the student loan repayments have to cover both the principal balance and any accrued interest.

What happens to unused money in a 529 plan?

Many people change the beneficiary of a 529 plan to another qualifying family member if the original beneficiary uses none or just some of the money for college.

Others transfer the money to a 529 ABLE account that a family member with a disability owns. Families who use this option have to make sure not to exceed the account’s annual contribution limit.

Starting in 2024, there will be another option for unused 529 plan funds. For accounts that are at least five years old, beneficiaries will be able to transfer up to $35,000 of unused money into a Roth IRA account in their name. Roth IRA annual contribution limits still apply.

Of course, 529 plan money could always be withdrawn for something other than educational costs. However, this is the least desirable option, as the earnings would then be considered taxable income and an additional 10% penalty would need to be paid, unless the beneficiary qualifies for one of the exceptions discussed above, in which case the penalty (but not the tax liability) is waived.

Can a 529 plan be used at schools outside the state that sponsors the plan?

Don’t worry; 529 plan funds can be used to attend a qualified school in any state.

However, 529 prepaid tuition plans work differently. The majority of prepaid tuition plans necessitate that the child or parents are state residents.

Depending on where you reside, there are often state tax advantages that come with these college savings plans. In many states, you may be able to get a tax break in the form of a state tax deduction or credit.

Can you lose money in a college fund?

Yes, it’s possible to lose money in a college investment account. Investment returns are not guaranteed and the account value can fluctuate, just as it does in your taxable brokerage or other investment accounts.

Depending on the type of college fund account, you may be able to use your own investment strategy to try and reach your investment objectives. In other situations, an education savings plan may only allow limited options. Either way, it’s possible to lose money. Fortunately, funds with limited options typically aren’t filled with very risky investments, so the chance of the value going down is low if you invest steadily throughout your child’s life prior to college.


About the Author

Riley Adams is the Founder and CEO of Young and the Invested. He is a licensed CPA who worked at Google as a Senior Financial Analyst overseeing advertising incentive programs for the company’s largest advertising partners and agencies. Previously, he worked as a utility regulatory strategy analyst at Entergy Corporation for six years in New Orleans.

His work has appeared in major publications like Kiplinger, MarketWatch, MSN, TurboTax, Nasdaq, Yahoo! Finance, The Globe and Mail, and CNBC’s Acorns. Riley currently holds areas of expertise in investing, taxes, real estate, cryptocurrencies and personal finance where he has been cited as an authoritative source in outlets like CNBC, Time, NBC News, APM’s Marketplace, HuffPost, Business Insider, Slate, NerdWallet, Investopedia, The Balance and Fast Company.

Riley holds a Masters of Science in Applied Economics and Demography from Pennsylvania State University and a Bachelor of Arts in Economics and Bachelor of Science in Business Administration and Finance from Centenary College of Louisiana.