What is the Right Way to Save?

In the last few articles I talked about how much college is going to cost and how much financial aid your student is likely to get. If you don’t yet have a specific number in mind as to how much you should save, you should. There are numerous calculators on our site that can walk you through that process.

Of course, knowing this number is only the first step. Now you have to figure out how you are actually going to save the money you will need. Here you generally have two choices: taxable accounts and tax-advantaged accounts.

Taxable accounts usually refer to traditional savings vehicles on which you pay taxes every year. They include:

• Mutual funds
• Stocks
• Bonds
• Certificates of deposit

With tax-advantaged accounts, you do not have to pay taxes on any of the earnings on the account (i.e., the capital gains, dividends or interest earned on your investments.) Tax-advantaged accounts include:

• Coverdell Education Savings Accounts
• 529 Savings Plans
• Retirement accounts
• Custodial Accounts, also known as UGMA/UTMA accounts

The best choice for most people saving for education is likely to be a tax-advantaged account because you’ll end up with more money. Putting $1,000 in a tax-advantaged account on the day your baby is born will yield nearly $4,000 18 years down the road, assuming an 8 percent rate of return. Investing $1,000 in a taxable account would bring less than $3,300 over that same number of years, assuming a 15 percent tax rate.

Before you pour all your money into a tax-advantaged account, however, be warned. If you don’t end up using the money for its designated purpose – either education or retirement – not only will you pay taxes on the money but a 10 percent penalty to boot. So if you are not certain the money you save will definitely be used for education, a taxable account is likely your best choice.

Before You Make That Choice, However...

Let’s first answer the all-important question: "How will saving affect the financial aid we get?"

We can’t emphasize this point enough: Keep as little savings as possible in your child’s name. This is because those accounts will do the most harm when you go looking for financial aid. Accounts in a parent’s name will affect the amount of financial aid far less. Accounts in a grandparent’s name or someone else’s name will have almost no effect.

Based on this information, and because of quirks in the rules about who the account owner is deemed to be, the different accounts will have the following effects on financial aid:

Greatest Reduction in Level of Aid

• Custodial Accounts (UGMA/UTMA)
• U.S. Savings Bonds, if issued in student’s name
• Traditional investments, if in student’s name

Moderate Reduction

• 529 Savings Plans owned by parents
• Coverdell Education Savings Accounts with parent as "responsible individual"
• U.S. Savings Bonds owned by parents
• Traditional investments owned by parents

Smallest or No Reduction

• Retirement accounts held by student or parent
• 529 Savings Plans owned by grandparent or other person for the benefit of the student
• Direct tuition contribution, if someone else pays the student’s tuition. This has no effect on financial aid and is also fully exempt from any gift tax restrictions. (Caveat: Such a gift tax exclusion only applies to tuition payments, not payments for room and board.)

Based on both tax ramifications and financial aid impact, you can start deciding which plan is best for you. We start doing that and making recommendations in Article Five.

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