How to Save for College With Pretax Dollars

In 2018, the average cost of college tuition and fees at a private school was $34,740. Sure, you can save some money by attending a state school, but even in-state residents can expect to spend nearly $10,000 on tuition and fees. It's no wonder that for many people, a degree is the most expensive purchase of their lives.

Because of the high cost of college education, parents and grandparents are often looking for ways to efficiently save for college. One way to make sure that you're saving the greatest amount possible is to choose college savings plans that have tax advantages. Finding plans that allow for pretax college savings means that you can put away money without the government taking a cut. Over time, the percentage that you save by using pretax college funds can dramatically affect how much you have to spend on education.

One of the most well-known pretax college savings plans is the 529 plan, officially called the qualified tuition program. A 529 plan is usually administered by the state, although it can also be administered by an educational institution. When you open a 529 plan, you name a beneficiary. The beneficiary is often a child or grandchild, although legally you can open a plan for anyone. Then, you can contribute pretax dollars to the plan. This means that the money you contribute to the 529 plan is not subject to federal tax and usually not subject to state tax either.

There are some important things to be aware of when it comes to 529 plans. If you contribute more than $14,000 in a year, your contributions might be taxed as a gift. In addition, the funds can only be used to pay for education expenses for the beneficiary. However, there are no tax penalties for changing the beneficiary to someone else in the family. If you end up using the money for something other than qualified education expenses, you'll have to pay federal tax and a 10 percent penalty on the earnings that your investments made while in the 529 plan.

Prepaid college savings plans are a unique type of 529 plan. These college savings plans allow you to stash away pretax dollars with an added advantage: You lock in today's tuition rates for your child's future education, meaning that you're spared the added cost of tuition hikes. Many states and some private colleges offer prepaid college savings plans. Most plans refund your money if your child chooses to attend a school that isn't covered by the plan. However, if the funds aren't used for education purposes, you'll have to pay federal tax plus the 10 percent fee, just like any other 529 plan.

Coverdell education savings accounts are a type of pretax college savings that were formerly known as Education IRAs. These accounts allow people to contribute up to $2,000 in pretax dollars each year to an investment fund for the education costs of the beneficiaries. These accounts are generally less popular than 529 plans because of the lower contribution limits and because of an income limit on who can open them. The income limit is $110,000 annually for individuals and $220,000 for couples.