Ways to Save for College Costs

PROS

 As of 2023, if a 529 plan is owned by a grandparent, aunt, uncle or other person, it is virtually invisible on the FAFSA’s calculations for both assets and won’t count as student income later if used for qualified expenses.

Although contributions to a 529 plan aren’t tax deductible on your federal tax return, the earnings grow tax-free when withdrawn and used for qualified education expenses.

Many states o­ffer state income tax deductions for contributions if you choose to invest in your state’s plan. (Your child can still attend college anywhere.)

There are no income limits on 529 plan contributions, so they’re available to everyone. Plans vary, but most have high total contribution limits—usually in the $235,000 to $529,000 range.

CONS

 If owned by a parent or student, a 529 plan is counted as an asset on the student’s FAFSA (free application for federal student aid), although only a percentage of the total account is calculated.

There are limited investment options available with 529 plans, and only one investment change per year is permitted. Some plans have high costs and fees.

If your child, you or any family member does not want to attend college, and if 529 plan money is withdrawn and not used for education expenses, the account’s earnings are subject to both income tax as well as a 10 percent penalty tax, and you may have to pay back any state income tax deduction amounts as well. (There are exceptions to 529 plan penalties if your student receives scholarships.)

PROS

 There is a lot of flexibility with a Roth—you can invest in nearly any type of account you want to within a Roth IRA wrapper.

If your child doesn’t choose to go to college, the money can be used for any purpose, including retirement, with no mandated withdrawals or RMDs (required minimum distributions) or taxes due. Inherited Roth IRA accounts are also tax-free.

CONS

 One of the difficulties with Roth IRAs is that high earners can’t open them, and the yearly limit in 2024 for contributions is only $7,000 (The 2024 contribution limit is $7,000 or $8,000 if you are 50 or older). In some cases, what’s called a “backdoor Roth” might be indicated for high earners, where they can legally convert taxable IRA funds into Roth IRA accounts and pay taxes on the money converted, but these are complex and strict IRS rules apply.

While a Roth IRA does not show up as an asset for financial aid calculations, amounts withdrawn and used for college expenses are considered income for the next school year, and therefore may reduce the amount of student financial aid that’s available.

 Many permanent cash value policies regularly credit the policy with interest in a guaranteed* amount specified in the policy terms (*guaranteed by the claims-paying strength of the issuing insurance company.)

Money borrowed from the cash value in a life insurance policy is not taxable in most cases. Interest credited to a life policy grows tax-deferred, but the credited interest portion is taxable if that part of the money is borrowed for any purpose, including college.

If the insured dies, the death benefit plus remaining cash value is almost always tax-free when left to individually-named beneficiaries.

Buying a flexible, permanent policy for a child at a young age when they are healthy can ensure that they are insurable even if there’s an unexpected future adverse event; for instance, if they develop a severe illness later.

CONS

 While a life insurance policy does not show up in financial aid calculations as an asset, amounts borrowed to pay for college are considered as income on the next year’s FAFSA, potentially reducing the amount of student financial aid available.

Life insurance policies can be costly for those who are older or in poor health. If you are using life insurance to pay for college, consider buying the policy when the child is a healthy toddler—with them as the insured to keep the cost of insurance low.

If you borrow money from the cash portion of a permanent life insurance policy, interest is charged by the insurance company on the amount borrowed until you pay the money back—in essence, you are paying “yourself” back—and regular premium payments must be made to keep the policy in force. It is advisable to work with a qualified professional to examine the structure of any policy so that you understand its terms.

PROS

Annuities can offer a tax-advantaged option for college costs in some cases because annuity policy growth is not taxed until funds are withdrawn.

You could purchase a fixed annuity with a short payout schedule to make payments to cover tuition, but you may have to contribute a significant amount to achieve the payout needed. Another way to potentially make an annuity work is to start early when your child is young and purchase a deferred annuity policy which guarantees* a high credited interest rate (*guaranteed by the claims-paying strength of the issuing insurance company).

CONS

While an annuity does not show up on the FAFSA as an asset, annuity amounts paid out are considered income the next year, which can reduce your student’s chances of receiving financial aid.

So rather than taking annuity payments while attending college, optionally you could take out student loans, allowing your annuity to continue to grow, then use the annuity to pay off­ the loans after graduation depending on interest rates, crediting rates, and whether or not it saves you money in the long run.