Pros and cons of using non-college accounts for college savings

Amy Fontinelle

By Amy Fontinelle
Amy Fontinelle is a personal finance writer focusing on budgeting, credit cards, mortgages, real estate, investing, and other topics.
Posted on Oct 22, 2019

Saving for college can be one of the more daunting tasks parents face. Besides how much to save, you need to choose where to put those savings.

Most families’ key considerations include:

1. Taxes: How can I reduce taxes to save more for college?

2. Risk: How do I invest my child’s college savings properly?

3. Flexibility: Will I be able to use the money for something else if my child doesn’t go to college?

4. Financial aid: How will saving affect scholarships, grants, and loans?

A variety of college savings programs are available to give families advantages in some or all of these areas. Perhaps the most well-known are 529 college savings programs . Unfortunately, findings from the latest MassMutual College Planning and Saving Study reveal that just 28 percent of families who expect their kids to attend a college or university intend to use vehicles like 529 plans to save. Most families are far more likely to use traditional methods of saving.

So how do accounts that aren’t specifically geared for college — general investment accounts, savings accounts, certificates of deposit, and Roth IRAs — stack up when it comes to paying for higher education and the four considerations above? (Calculator: How much to save for college? )

General investment accounts

General investment accounts typically do not offer state or federal tax breaks.

The lack of tax breaks means that money saved and invested in a general investment account may not grow to as large a sum as it would in a college savings plan, assuming the same rate of return for both types of accounts. If the child is young when you open the investment account, the same sum saved in a 529 plan could achieve larger returns because its investment gains are not taxed federally when the money is spent on education (see IRS Publication 970 for details).

But general investment accounts are flexible. Parents retain total control of their money, can use it for any purpose, and can invest it however they want, as long as the money is in the parents' name and not the child’s. If the child doesn’t go to college or doesn’t use all the money for college, the parents can use it for something else, such as retirement, without penalty. (Related: Custodial accounts and Coverdells )

And the money in such investment accounts also has a low impact on financial aid. (Related: A primer on financial college aid )

“As far as FAFSA [Free Application for Federal Student Aid] goes, a general investment account and a 529 college savings account are treated the same way. In a parent’s name, up to 5.64 percent is added to the expected family contribution,” said Jim Anderson, a college and financial aid planner with Making College Worth It in Marietta, Georgia.

For those families who desire such flexibility and want to be hands-on with investments, the operating expenses and restricted investment choices of many 529 plans may be off-putting. So may the 10 percent penalty on earnings withdrawn for non-educational expenses.

For families less active in investing, 529 college savings plans may be more manageable. Many 529 plans offer easy asset allocation strategies based on the child’s age. The portfolio may take more risk aiming for higher returns when the child is young, then grow more conservative as the child approaches 18. In a general investment account, parents may need to take a more hands-on approach to preserving principal as college nears — and some parents may prefer that. Many 529 plans do offer options other than age-based ones, however.

Parents can also choose to invest in a different state’s 529 plan if they don’t like their own state’s plan. They may lose some state tax breaks, but the federal tax savings could still make a 529 more appealing than a general investment account.

Savings accounts and certificates of deposit

Putting money in a savings account is one of the simplest ways to save. It’s also considered low risk because it largely preserves your principal. But it’s not entirely without risk because of inflation and opportunity cost.

  • Inflation: Even with a high-yield account, the interest you’ll earn might not be enough to keep up with tuition inflation.
  • Opportunity cost: You might earn better returns through market-based investments.

Certificates of deposit also protect principal and can offer better returns than savings accounts, but may still earn much less than stocks and bonds over the long run. Additionally, there are typically no tax breaks on CDs or savings deposits, so what little returns you do earn will likely be diminished each year by federal and state taxes.

When are savings accounts and CDs best for college savings?

“This strategy might be a good one for older children with fewer years for growth,” Anderson said. “If it were me, I’d hate to see a market correction right before needing to make college payments.”

Even if you’re further out, these options may be right for you if you can’t stomach the ups and downs of the market. (Related: Why identifying your risk profile is essential to investing )

As with investment accounts, savings accounts and certificates of deposit give parents complete flexibility over how and when to use the money. And again, as parental assets, only about 5 percent of the money counts toward the family’s expected contribution to college expenses in financial aid calculations.

What are the biggest potential disadvantages of saving this way? You may miss out on the higher returns and tax savings you could achieve by investing in stocks and bonds through a 529 college savings plan or even a general investment account.

Roth IRAs

A Roth IRA is a retirement savings account, not a college savings account. So, from a parent’s perspective, it might seem like a more flexible savings option. The thought is that they’ll take Roth withdrawals if their child needs college money. But if not, the parent can use the money for retirement.

Using Roth withdrawals for college isn’t impossible. The IRS normally levies a 10 percent penalty tax when someone younger than 59½ withdraws any investment earnings from the account. But it usually doesn’t levy this penalty on withdrawals of investment earnings used to pay for qualified higher education expenses at an eligible educational institution. This is generally true as long as the withdrawal pays for the parent’s own education or for the education of a spouse, child, or grandchild.

While the 10 percent penalty tax may not apply, income tax on earnings does apply unless the parent is 59½ or older. This tax on withdrawn earnings can put the Roth IRA at a disadvantage compared with a 529 savings plan. The IRS does not tax 529 earnings that are used for qualified higher education expenses.

Roth IRAs, like general investment accounts, do offer typically more investment options than 529 plans. Within a state’s 529 college savings plan or plans, you’ll be limited to a list of preapproved investments. There’s a good chance they’re similar to what you’d choose even if you had more options, but their expenses might be slightly higher than you’d incur for comparable investments in a Roth. Most families will likely find that a 529’s tax savings outweigh such small differences in investment fees, however.

Related: Mutual fund and ETF basics

Where families can run into big problems with using a Roth IRA to pay for college is in financial aid calculations. For wealthy families who will not be eligible for financial aid, this consideration may not matter. But families who expect to qualify or want to preserve their chances to qualify should know that Roth withdrawals are counted as parental income, and 22–47 percent of a parent’s discretionary income is counted toward the family’s expected financial contribution. This is true even if your withdrawal consists entirely of returned contributions and doesn’t include any investment gains.

Parents should also consider how using Roth withdrawals to pay for a child’s college expenses would affect their own finances later on.

“A Roth is generally a retirement savings vehicle for most people,” said Joseph Bogardus , a financial planner with Barnum Financial Group in Shelton, Connecticut. “Tapping into retirement funds for college can cause a lot of headaches and heartaches when the parents get older — possibly even on the part of the youngster whom the parents helped.”

Learn more: Why saving for retirement early is important

Conclusion

General investment accounts, savings accounts, CDs, and Roth IRAs are all valid ways to save for college, and they’re probably better than not saving for college at all. Families must decide if the flexibility gained from not being required to use these accounts for education expenses outweighs what they give up by not using an account whose tax advantages, financial aid considerations, and investment options are specifically designed for college. Working with a financial planner who can evaluate the family’s whole picture may be an option to make the decision a little easier.

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The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.