60% of parents could be making a big college savings mistake

Americans are doing a great job of saving for college overall. Six out of 10 parents are actively saving for college costs, and 86% of parents with a college savings goal feel confident that they'll meet it. And far fewer parents say they'll need to dip into their retirement savings to help pay for college than just a few years ago -- an extremely positive development for the retirement well-being of Americans.

Having said that, there's always room for improvement. Specifically, it's where Americans are stashing their college savings that is a bit concerning. By not taking advantage of college-specific savings options, more than half of college-saving parents could be missing out on valuable tax benefits and growth opportunities.

Where Americans put their college savings

According to Salle Mae's How America Saves for College 2018 report, parents who are saving for college have accumulated $18,135 on average. Here's how that money is distributed, by account type:

Type of Account

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% of College Funds in This Account Type

Data source: Sallie Mae How America Saves for College 2018 report.

Here's the key takeaway. Only 40% of America's college savings are in vehicles specifically designed for college savings:

• 529 savings plans (30%) are run by the states and work similarly to 401(k) accounts in terms of investment selection. There are generally a selection of a couple dozen investment options, including age-based portfolios that gradually become more conservative over time and static options that focus on one investment objective. Tax-wise, 529 savings plans work like Roth IRAs, where contributions are not deductible, but qualified withdrawals are tax-free.
• Prepaid tuition plans (8%) are offered by fewer than 10 states but are quite popular where they are available. These essentially allow parents to purchase "units" of tuition at current prices, to be used in the future.
• Coverdell Education Savings Accounts, or ESAs, (2%) are investment accounts that allow college savers to invest their funds in virtually any stock, bond, or fund they want. If you want to invest some of your newborn child's college savings in Apple stock, for example, a Coverdell ESA allows you to do it. Like 529 savings plans, Coverdell ESAs also allow tax-free withdrawals for qualified expenses.

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The problem

As I mentioned already, Americans as a whole are doing a good job of saving for college.

However, one lingering problem is the 60% of Americans who aren't using a college-specific savings vehicle, such as a 529 savings plan, Coverdell ESA, or prepaid state plan.

Thirty-five percent of college funds are kept in savings accounts, checking accounts, and CDs. And the funds in these accounts are earning little to no returns, especially over the past few years. Sure, interest rates have started to rise recently, but most savings and checking accounts still pay extremely low interest. On the other hand, money in college-specific accounts can be invested and grow over time. Even some of the conservative investment options in these types of accounts handily beat savings accounts over time. Stock- and bond-based investments do involve some risk, so be sure you know what you're getting into, but they do give you a great chance to grow your child's college fund over time.

The 14% of Americans who use a standard investment account for college savings are at least putting themselves in a position to earn reasonable returns on their money, but they are missing out on one important thing: tax advantages.

Specifically, 529 savings plans and Coverdell ESAs are both tax-advantaged accounts. Money in these accounts is allowed to grow on a tax-deferred basis, and any withdrawals for qualified educational expenses are completely tax-free. In addition, many states give 529 participants a deduction on their state income taxes for their contributions. If you plan to contribute a total of $30,000 to your child's college fund over the years, and your state has a 5% income tax rate, this translates to an additional $1,500 in your pocket.

To be clear, there are certainly some good reasons for not investing college savings. For example, if your child is 16 or 17, it would be silly to put their college savings in the stock market knowing they'll need it within the next few years. There's always the risk of losing money when you invest, especially over relatively short periods of time.

Even so, the tax benefits of a state-deductible 529 savings plan can still make more sense than a savings or checking account, even if you plan to keep your investments in cash and money market instruments.

Tax savings plus investment growth are a winning combination

The point is, if you're saving for college in a checking account, savings account, CD, or even a standard investment account, it could be a smart idea to look into the college-specific options. These often have low-cost, low-maintenance investment choices ranging from aggressive to ultra-conservative, and they have tax advantages that can keep lots of your hard-earned savings out of the IRS's pocket.

Not all states offer prepaid tuition plans, and 529 savings plans and Coverdell ESAs each have their advantages and disadvantages, but for most people, utilizing one of these options is the smartest way to save for college.

Matthew Frankel owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

The Motley Fool is a USA TODAY content partner offering financial news, analysis and commentary designed to help people take control of their financial lives. Its content is produced independently of USA TODAY.

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