How to Save for College: 529 Plan vs. CD

It’s literally never too early to start thinking about funding a college savings account for your child, considering that current tuition and fees can range from $10,560 a year at a public four-year in-state school to a whopping $37,650 for a private four-year school. And unfortunately, college costs are expected to continue to skyrocket—according to EducationData.org, the cost of college has tripled in two decades, growing an average of 6.8% per year.

To make a dent in that wallet-busting figure, you need time on your side, which is why savvy parents know that socking away money while their child is young is key. Two of the most popular low-risk options for funding a college savings account are 529 plans and CDs. Let’s compare the pros and cons of each to see which one might better suit your financial needs, family situation and risk tolerance as you save for college.

Pros and Cons of 529 for College

What is a 529 plan? Named for the section of the Internal Revenue Code that created them, 529 plans are specifically designed for college savings and offer a number of tax advantages.

Pros:

• Your contributions grow tax-deferred.
• Withdrawals are also free from federal income taxes—as long as the money is used for “qualified college costs,” which include tuition, fees, room and board, books and even technology.
• They can be used at any accredited college—private or public—in the United States and many overseas as well.
• There are no income or age limits.
• Any third-party source can make contributions. (Hint: Let adoring grandparents and aunts and uncles know this is a much better gift idea than another raucous plastic toy.)
• Most plans use “age-based portfolios,” which means the fund will automatically adjust into safer choices as your child nears college age, eliminating worries of a market downturn that could diminish your savings.

Cons:

• The money has to be designated for one specific “beneficiary” (i.e. your child). However, if your child decides to forgo college or earns a scholarship that covers the bulk of the cost, you can change the beneficiary to another family member. You can take advantage of that once per calendar year.
• The money has to be used for qualified college expenses, or you will face a 10% tax penalty if it is used for any other reason.
• Your state plan might not offer tax advantages. However, although each state and the District of Columbia offers at least one 529 plan, you can invest in any one you choose, no matter where you live or where your child eventually attends college. The plan finder at Savingforcollege.com is a great place to start to compare your options.
• You will have to pay various fees for administration, which can eat into your returns so you need to carefully research the associated costs when choosing your plan.
• The tax advantages benefit you most when you save over the long term, so a 529 may not be as appealing if your child is already in high school as if you had started earlier.
• But most important to note, your investment is not guaranteed so you could lose your money if the market falls.

Pros and Cons of CD for College

What is a CD? A Certificate of Deposit (CD) is an investment product that is designed to pay a fixed interest rate for a designated period of time. After that time is up, known as “maturity,” you’ll receive your original investment back, along with the stated interest.

Pros:

• With a guaranteed return, you know exactly how much money you have saved so you can plan better.
• Your money is safe; you won’t lose your investment, which provides peace of mind when the market fluctuates.
• You can create a plan that allows you to save over the long run, using a “CD ladder.” For this you buy a series of CDs with different term limits, timing the maturity date to coincide with expected tuition payments. With this strategy, you’ll receive income at different times while still taking advantage of the interest rate returns. (Your advisor can help you plan this for the maximum benefit.)
• CDs are flexible, which means you can use them for anything in case your family’s plans change, even if you had initially planned to use them for college.

Cons:

• You will have to pay a penalty if you need to withdraw the money before the term is up.
• CDs don’t have any specific tax advantages, which means you’ll pay tax on the interest that accrues.
• If inflation grows, it could outpace the rate of return, meaning that the CD has less purchasing power when you cash it in.
• With a fixed interest rate, you are locked into a specific amount, even if interest rates rise during that time.
• The relative return is often smaller than what you might get with a 529 plan, especially if that plan is invested in more aggressive stocks, which is common when you have a longer time horizon until you need it (i.e. you start investing when your child is quite young).

Consider a Combination for Your College Savings Account

Some plans allow you to buy a “529 CD,” which offers you the benefits of a guaranteed rate of return during the CD term and then it transfers to your 529 plan when it matures.

Save for Yourself First

Whatever choice you decide to make as you consider a college savings account, don’t sacrifice your own retirement contributions.

While funding your child’s college plan is a worthy goal, you want to make sure it’s not at the expense of your own retirement funds. Because while there are many options, such as grants, scholarships and loans, available to help offset college costs, there are no such programs for your golden years.

Remember, there is no one-size-fits-all strategy, and your college savings plan should reflect your own individual goals and financial situation.