Most Parents Saving for Kids’ College Education in Wrong Places

With their children facing an average student loan debt of $33,000 when they graduate from college, some parents are helping by saving for their kids’ college education in various accounts.

They mean well, but they may be doing themselves and their children a disservice with less money saved and less tax relief.

Along with the traditional ways of saving for college with a 529 or a Coverdell Education Savings Account, parents are also saving for a college education through savings accounts and their retirement plans.

45% save for college in savings account

A recent study by T. Rowe Price found that 45 percent of parents saving for their kids’ college education are using a regular savings account, and 30 percent are using their 401(k) retirement account.

The study found that 31 percent are using a 529 account that’s designed to give them the most taxable savings when saving for college.

By not using a college savings account, they’re not only losing tax benefits, but may be making a lot less money on the interest rates the accounts make. And even if they’re making more money in a retirement account, that benefit may be lost when it’s time to pay income taxes.

Using a comparison calculator at Savingforcollege.com and researching federal income tax rates and average returns, here are how different savings vehicles would help in saving for a college education:

529 Plan

Federal income tax: Non-deductible contributions; withdrawn earnings excluded from income to extent of qualified higher education expenses.

Rate of return: Returns vary by state, but the Colorado plan, for example, has a return rate of 3.09 percent per year in 2015.

Overall, an average rate of return of 6-7 percent could be expected in a 529 plan for a college education.

Coverdell

Federal income tax: Non-deductible contributions; withdrawn earnings excluded from income to extent of qualified higher education expenses and qualified K-12 expenses also excluded.

Rate of return: One online calculator puts the default return rate for a Coverdell account at 8 percent. A Franklin Templeton guide to Coverdells also puts the average annual return at 8 percent.

Making a $2,000 contribution to a Coverdell account each year for 18 years with an 8 percent average annual return, compounded monthly, would result in $16,448 more in a tax-deferred investment than in a taxable investment, according to the guide. The tax-deferred Coverdell account in this scenario would have $83,524 after 18 years.

Savings account

Federal income tax: Interest earned on savings account is taxed as income.

Rate of return: As of Sept. 10, 2015, the standard rate of return for a money market savings account at Bank of America was 0.03 percent. We only chose BoA because it’s one of the biggest banks in the country.

One-year certificates of deposit are averaging 0.23 percent. That just barely beats the U.S. inflation rate of 0.2 percent.

U.S. savings bonds

Federal income tax: Tax-deferred for federal; tax-free for state; certain post-1989 EE and I bonds may be redeemed federal tax-free for qualified higher education expenses.

Rate of return: Series EE bonds pay 0.30 percent after 20 years, which is almost enough time before a newborn starts college.

Roth IRA

Federal income tax: Non-deductible contributions; withdrawn earnings excluded from income after age 59 1/2 – and five years; 10 percent penalty on early withdrawals waived if used for qualified higher education expenses.

Rate of return: The S&P 500 has an annual rate of return of 8.06 percent for the past 10 years. From January 1970 through December 2014 the S&P 500 has a return of 10.7 percent.

Traditional IRA

Federal income tax: Deductible or non-deductible contributions; withdrawals in excess of basis subject to tax; 10 percent penalty on early withdrawals waived if used for qualified higher education expenses.

Rate of return: Fidelity gives the example of a 7 percent rate of return for an IRA contribution.

401(k) retirement account

Federal income tax: Same as for a traditional IRA, except there isn’t a penalty waiver if the money is used for college expenses. In other words, a 401(k) shouldn’t be used to pay for college.

A loan from a 401(k) retirement plan can be taken out. Plan loans aren’t taxed or penalized if the loan is repaid within a specific period of time, generally within five years.

Rate of return: The Vanguard Wellington mutual fund, which is one of the most common balanced funds found in 401(k) plans, has an average annual five-year return rate of 12.07 percent as of June 30, 2015. Pulling money out through a loan to fund a college education would of course lessen the amount of money earning the return rate.

How to pay for a college education

Among all of these methods, borrowing or withdrawing money from a retirement account to pay for a college education seems like the biggest potential for not making as much money as you would through an education savings accounts. You might get a higher rate of return, but the tax implications could negate it.

But as college appears closer and closer, maybe that’s the best choice for parents who have put off or completely ignored saving for their child’s college education from the day they were born. Thinking seriously about it when high school graduation is only a few years away may help their kid get through college without any debt, but they may be giving up part of their retirement plans in the process.

If that’s the case, make sure your child graduates with a college education in a well-paying major so they can help support you in your old age.