The smartest ways to save for college

College savings are a high priority, with over 50 percent of families establishing accounts. That's according to the recently released report, "How America Saves for College 2014," an annual study by Sallie Mae, a leading student lender.

Among families saving for college, the average savings across all college accounts is over $15,300, a 30 percent increase over last year. As you would expect, the average amount saved by families with teen students is higher than for families with children ages 7-12 ($21,400 versus $16,500).

But looking deeper into the report, you'll find that where folks put their savings into action indicates a scattered approach to this important savings goal.

While many families use special vehicles specifically designed for college savings, the largest percentage of use general bank savings accounts (45 percent) and checking accounts (24 percent.) The problem with them is that the interest rate on the money saved is nearly zero, while college costs continue to rise at about 5 percent per year. So, saving for college in a bank checking or savings account is a guaranteed way to lose purchasing power over time.

Over a third of families saving for college are using investment vehicles specifically designed to build their college savings, which helps make the future cost of college more affordable. The three most widely used vehicles are 529 college savings plans (29 percent), prepaid state college savings plans (14%) and Coverdell Education Savings Accounts, or ESAs, (13%).

Prepaid state college savings plans are a good option for folks who are more certain of the college their student will attend. But if you want more flexibility, I think the Coverdell ESA and 529 plans are both excellent because they both allow you to use the savings toward any college, while also featuring tax-sheltered growth of investment gains, which are tax-free when used for college.

But when faced with the choice, should you use a 529 education savings plan or a Coverdell ESA?

For starters, the maximum amount you can save in an ESA is $2,000 each year, so if you want to save more, you'll need to put the additional savings into a 529 plan, which means you'll be using both an ESA and a 529 plan.

ESAs have two benefits over 529s. First, only the Coverdell ESA allows you to self-direct your investments in a brokerage account, similar to how you might self-direct the investments in your IRA. The second reason is that money can be withdrawn from an ESA tax-free for K-12 and for college expenses, while tax-free withdrawals from 529 plans are limited to college expenses.

Families planning to send their children to private grade school seem to favor the ESA for this reason. But the ability to use an ESA phases out for families with incomes between $190,000 and $220,000 ($95,000 and $110,000 for single filers). Finally, ESAs have age and use restrictions: Contributions must be made before the beneficiary is age 18, and the account must be fully distributed by age 30.

529 plans don't impose annual contribution limits, age limits or income limits like the Coverdell ESA. Also, your state may allow a state tax deduction for the contributions you make into its 529 plan. No states are offering a state tax deduction for contributions to a Coverdell ESA. Finally, many state-sponsored 529 plans offer a wide variety of investment choices, so self-directed investment choices allowed in ESAs don't seem to be enough of an advantage to get many college savers to use them.

Finally, both ESAs and 529s feature the same advantage of being counted as an asset of a parent for federal financial aid purposes as long as the parent owns the account.

For the reasons mentioned here, 529 plans are the better choice for most college savers.
  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.

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