Account types you might want to avoid
Many types of accounts can be used to save for college, but some of them may not be the best options. Here's what you should know.
Using a Roth IRA for college
Some people use a Roth IRA to save for college instead of retirement because withdrawals are exempt from penalties when used for pay for qualified education expenses (like tuition, fees, books, and room and board).
However, when used to pay for college, these withdrawals are not exempt from income tax on earnings unless the account owner is age 59½ or older.**
Even if you'll be over age 59½ when you need your college money, you'll still need to consider these points:
Using a Roth IRA could mean less money for retirement.
You can only contribute a certain amount per year to all your IRAs combined, so money you save for college in an IRA is money you can't save for retirement.
You must keep the money in the Roth IRA for at least 5 years.
If you take money out of a Roth IRA before you've owned the account for 5 years, you'll owe taxes and be charged a 10% penalty on the earnings.**
You may not be able to contribute as much as you intended.
The 2015 IRA contribution limit is $5,500—$6,500 if you're age 50 or older.
Your financial aid package could take a hit.
Money you have saved in IRAs isn't initially counted when financial aid packages are put together. However, when you take money out to pay college expenses, it will be considered income for that year—and weigh against you much more heavily the following year.
Using whole life insurance for college
Insurance companies sometimes sell whole life insurance policies as a way to save for college too. It might sound like a good deal, but watch out for these downsides.
You could tie up your money for many years.
You can usually get the "cash value" of your policy back whenever you want, but it typically takes years before that cash value equals the amount you've given the insurance company.
You probably won't get much in return.
These policies typically pay only a couple percentage points in annual returns. If you're locked into a fixed rate that's lower than what the financial markets return—and over 18 years, that's more likely than not—you'll be giving up money you could have used for college.
Your financial aid package could take a hit.
As with a Roth IRA, the cash value of your policy won't be counted as savings—but once you withdraw money, it will be counted as income and cut your financial aid package the following year.
You could pay a lot more.
Costs for whole life insurance policies are usually much higher than those you'd pay for low-cost investments available through other account types. Again, this means less money for college bills.
Using a bank account or CDs for college
As a parent, you're sure to feel that your main role is to protect your children—and that might translate into a desire to protect your college savings from the possibility of loss.
But remember that losses on investments aren't "locked in" until you sell the investment, and not all investments are equally risky. When you have a lot of time to let your money grow, taking on a little more risk can make a huge difference.
And taking on some risk might be necessary if you want the value of your savings to keep pace with inflation in college prices.
For example, imagine you saved $25 a week for 18 years, and kept it in a bank account earning 1% annual interest. When it's time for college, you'd have about $25,750—the $23,400 you put in and about $2,350 in interest.
Now imagine you invested the money and earned 6% a year. After 18 years, you'd have about $42,600 instead.
That's almost $17,000 extra—additional money that could go a long way toward helping protect your child's college dreams.
Give your savings a chance to grow
This hypothetical illustration assumes a monthly deposit for 18 years, for all examples. This illustration does not represent any particular investment nor does it account for inflation. There may be other material differences between investment products that must be considered prior to investing.
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A type of IRA that allows you to make after-tax contributions (so you don't get an immediate tax deduction) and then withdraw money in retirement tax-free as long as you meet the requirements.
A type of account created by the IRS that offers tax benefits when you use it to save for retirement.
The yearly, monthly, or weekly amounts you save in your account.
Contributions you can subtract from your income on your tax return, resulting in a lower tax bill.
Money you can take out of your account without owing any federal income tax, even if some of it has never been taxed.
The investment returns you accumulate on the savings in your account.
Usually refers to investment risk, which is a measure of how likely it is that you could lose money in an investment. However, there are other types of risk when it comes to investing.