The birth of your first child is an exciting milestone, but it often comes with questions you may have never considered before. One of the biggest questions new parents face is how to not only pay for college but also set their children up for long-term financial success. Recently, I’ve been fielding many questions from parents about the best types of accounts to use for these goals.
Planning ahead is essential—it won't be cheap—but with the right strategy, you can give your child a strong financial foundation for the future.
Before we dive into specific account options, it's important to remember that setting your financial priorities is key. While we all want to give our children the best possible start, it’s vital to ensure you’re also on track for your own financial goals, especially retirement. Remember, you can borrow for college, but you can’t borrow for retirement.
Tuition costs continue to rise, with an expected growth rate of around 8% per year. While that might sound overwhelming, if you’ve been following my blog you know that time and compound interest are your best allies. When it comes to saving for education, there are four main options:
529 Plans
Taxable Brokerage Accounts
UTMA/UGMA Accounts
Cash Flow
We won’t be diving into student loans here, since they're not technically "savings accounts." Student loans, if necessary, would cover any remaining gap and are typically the responsibility of the student.
1. 529 Plans
The 529 Plan is one of the most popular and well-known ways to save for college because it was specifically designed for educational expenses. A 529 is a tax-advantaged account that must be used for qualified educational costs, including private high school, college, and even trade schools. These accounts are sponsored by states, and depending on your state, they may come with additional tax benefits.
Pros:
Tax-free growth when used for qualified educational expenses
Flexibility to transfer to another family member if one child doesn’t use it
Recent legislation allows for some funds to be rolled over into a Roth IRA
Cons:
Must be used for educational purposes; otherwise, earnings are subject to taxes and a 10% penalty if withdrawn for non-qualified expenses.
Some people feel limited by its primary use being for college, and many parents prefer accounts with more flexibility for other future needs.
New Legislation: 529 Plan to Roth IRA Conversion
Thanks to the SECURE Act 2.0, 529 plans have become more flexible. Starting in 2024, leftover 529 funds can be rolled into a Roth IRA for the beneficiary, up to $35,000 over their lifetime. This provides a great opportunity to transfer excess funds into a retirement account if they don’t end up needing the full 529 amount for education.
2. Taxable Brokerage Accounts
A taxable brokerage account is an incredibly flexible option, allowing you to fund and invest with almost no restrictions. Unlike a 529 Plan, there are no contribution limits or penalties for accessing funds at any time. If you hold investments for more than 12 months, you'll only pay long-term capital gains tax on any earnings.
Pros:
Full flexibility with no limits on contributions or what the funds can be used for
You control the account and the investment choices
No penalties for accessing funds whenever you need them
Cons:
No upfront tax advantages
No tax-deferred growth
Dividends taxed annually at ordinary income tax rates
3. UTMA/UGMA Accounts
These accounts are similar to taxable brokerage accounts with one key difference: they eventually belong to your child. Once your child reaches the age of majority (typically 18 or 21, depending on your state), the funds legally become theirs. This can be a drawback for parents who want to maintain control over how the money is spent.
Pros:
Flexibility in how the funds are invested and used
Can be used for a wide range of purposes beyond education, including a first home or business venture
Cons:
Once your child reaches adulthood, the funds are theirs to use as they see fit—no strings attached
Potentially higher taxes on earnings, depending on how the account is structured
4. Cash Flow
Another option is to simply cash flow your child’s tuition payments as they come due. If you’ve already planned ahead for retirement and have a strong cash flow surplus, this can work, though it’s not always the most ideal solution.
One of the biggest concerns with this approach is that parents often end up sacrificing their retirement savings to cover college costs—a mistake you want to avoid. You only get one shot at retirement, and it’s important to prioritize that over funding your child’s education.
For instance, my parents cash-flowed my education even though I had a scholarship. While I’m forever grateful, I now realize that money could have been better used saving for their own retirement.
Other Options: Roth IRA for Kids
A less traditional option to consider is a Roth IRA for your child. If your child has earned income, you can open a Roth IRA in their name. While not specifically an education account, contributions can be withdrawn tax-free for any purpose, including college expenses. Plus, it gives your child a head start on retirement savings.
This is a great option for parents looking to set their child up for long-term financial success, not just education. However, the child must have earned income to qualify.
Comparing Tax Efficiency
It’s also helpful to compare how each of these accounts performs when it comes to tax efficiency. Here’s a quick breakdown:
Account Type | Tax Advantages | Limitations |
529 Plan | Tax-free growth for educational expenses | 10% penalty + taxes on non-qualified withdrawals |
Taxable Brokerage | Long-term capital gains rates | No upfront tax benefit |
UTMA/UGMA | Gains taxed at child's tax rate | Funds belong to child at age of majority |
Roth IRA (for child) | Tax-free growth & withdrawals of contributions | Must have earned income |
Estate Planning Benefits
For parents thinking about long-term financial planning, some of these accounts also offer estate planning benefits. For instance, contributions to a 529 plan can be treated as part of your estate planning strategy, as they are considered completed gifts. This can help reduce estate taxes while also benefiting your child's future.
So, What’s the Best Option?
The answer depends on your goals and preferences. Do you want maximum control over the funds? Are tax advantages important to you? Flexibility in how the money is used?
A common strategy is to use a combination of accounts. For example, you might fund a 529 Plan to take advantage of the tax savings and then use a taxable brokerage account for more flexibility. The key takeaway is to start planning now. While you can’t predict whether your child will get a scholarship or how the higher education landscape will change in the next 18 years, starting early gives you the best chance to adapt as life unfolds.
Practical Next Steps
So, what should you do next? Start by reviewing your financial priorities and deciding what makes the most sense for your family. If you're unsure which accounts to prioritize, meeting with a firm like WealthBound can help you tailor a strategy that works for both your current financial situation and your future goals. Remember, the earlier you start saving, the more time you give your money to grow.
Disclaimer: None of this should be seen as advice. This is all for informational purposes. Consult your legal, tax, and financial team before making any changes to your financial plan.