by Paula Pant
If you've got kids, it's time to start planning for their education -- even if they're still in diapers.
The cost of a college education these days (average yearly tuition for 2013-2014) ranges from $8,000 for in-state public college students to $30,000 for private college students, and historically rises faster than the level of inflation. Given that harsh reality, your best strategy is to develop a savings plan early -- as in, by your child's first birthday.
To get you started, here are five basic ways you can start putting money away for your child (or children's) education.
1. 529 Savings Plan
The money you set aside in a 529 Savings Plan will grow tax-free, can be withdrawn tax-free, and can be used for any accredited college or university nationwide.
You don't need a ton of money to start--as little as $25 can be used to open a 529 savings plan--and there is a maximum lifetime contribution, but it's a high one (between $235,000 and $300,000, depending on your state).
529 Savings Plans work much the way a 401K or IRA does. Your money is invested in mutual funds or other investment vehicles. While your contributions are not tax-deductible, the investments grow tax-free and distributions can be spent tax-free on qualified educational expenses. (You may need to pay state or local taxes, but distributions are free from federal tax.)
Under most plans, your choice of school isn't impacted by the state that administers your 529 plan. You can live in California, for example, while contributing to a 529 plan that's based in Vermont - and at the last minute, your child can decide to attend college in Ohio. That's totally fine; you'll still enjoy the benefits.
2. 529 Prepaid Tuition Plan
If you know your child will attend college in-state, you could also opt to pre-pay for their education through a 529 Prepaid Tuition Plan--and wind up saving yourself a ton of money.
529 Prepaid Tuition Plans allow you to purchase shares worth a certain percentage of tuition at a state college of your choice. These shares will always be worth that percentage, even if (or rather, when) tuition rates rise in the coming years. So you can pre-pay for, say, a full year's tuition at today's prices, and your child will still be covered for a full year's tuition when she's ready to attend college, even if that's 10 years down the road and tuition costs have doubled.
These plans can be converted for use at out-of-state schools and private schools, but they may not wind up covering as much as they would at an in-state school, so be prepared to cover the difference if your child opts to go this route.
3. Coverdell Education Savings Account (ESA)
Formerly known as Education IRAs, Coverdell ESAs work similarly to traditional retirement IRAs. You are able to contribute a certain non-deductible amount (up to $2,000 per year per beneficiary as of 2015) which then grows tax-free and can also be withdrawn tax-free, so long as you're using it for educational purposes.
The main difference between an ESA and a 529 Savings Plan is that with an ESA, your investments are self-directed, meaning you get to choose how and where your money is allocated. (This could be a perk or a drawback, depending on your personal preference.)
Coverdell ESA funds may also be used for primary and secondary education expenses, while 529 funds can only be used on college costs. If you're thinking of funding a private education for your children for grades K-12, a Coverdell ESA can help you with that.
Note: You can only contribute to a Coverdell ESA if your modified adjusted gross income is under $110,000 if you're single or $220,000 if you're married filing jointly.
4. Roth IRA
Another option available to you is to open a Roth IRA and use it both for your own retirement savings and saving for your kids' education. The benefit here is that, should your children decide to go to a less expensive school than you've planned for, to attend a 2-year school rather than a 4-year school, or not to attend college at all, you can convert any unused funds you've earmarked for them into retirement savings for yourself with no tax repercussions or other penalties.
If you have unused funds in a 529 account, you are able to withdraw them for non-educational purposes, but your withdrawal will be subject to federal income tax and will also face a 10 percent penalty fee.
5. Custodial Account
If you want ultimate freedom over your investments, you may want to consider a custodial account. This is a savings account opened in your child's name of which you are in charge until your child reaches the age of legal adulthood. Bear in mind, however, that with extra freedom comes extra fees.
There are no caps on how much money you can put into a custodial account, but any contributions above $850 per year will be subject to federal tax and amounts over $12,000 are subject to gift tax. Other family members, such as grandparents, are able to add money to the account. You can withdraw funds at any time, for any purpose, without paying a penalty, but withdrawals are subject to federal tax.
Once your child reaches adulthood, the funds become theirs to do with as they please, so if you're not entirely confident your child will put that money towards legitimate educational purposes, you may be better off opting for a different savings strategy.