Should You Use a High-Yield Savings Account to Save for College?

Are High-Yield Savings Accounts Good for College Savings?

High-yield savings accounts function the same as traditional savings accounts, except they offer a much higher interest rate. They also offer easy access to your funds through a transfer to your checking account or sometimes even an ATM card.

High-yield savings accounts typically don't charge monthly fees, and the rate of interest you earn will depend on current market conditions. Here are some pros and cons of high-yield savings accounts.

Pros of Using a High-Yield Savings Account for College

• Fewer withdrawal limitations: Other college savings vehicles, such as 529 plans or Coverdell Education Savings Accounts, may penalize you for taking money out for costs that aren't on the IRS list of qualified educational expenses. You won't get that with a high-yield savings account, which gives you a bit more flexibility. That said, you may be limited to just six withdrawals per month.
• Safe returns: A high-yield savings account may not provide the same return potential as an investment account. But if you're starting to save for a college education while you or your child is in high school, investing your money could expose you to short-term market volatility, which could result in your account losing value. With a high-yield savings account, there's no possibility of losing money due to the market.

Cons of Using a High-Yield Savings Account for College

• Lower returns: Interest rates on high-yield savings accounts can fluctuate over time, but they're generally never high enough to outpace inflation. In contrast, while investments carry risk, they also offer the potential for a higher return, especially over a long period of time.
• Interest is taxable: Interest earned on a high-yield savings account is taxable, but that's not the case with a 529 plan or Coverdell ESA, as long as you use the funds for qualified expenses. What's more, some states offer tax deductions or credits on 529 plan contributions.
• Risk of using it for other purposes: Because there are no penalties for withdrawing money for non-educational expenses, you may be tempted to dip into your high-yield savings accounts for other purposes, making it more difficult to achieve your goal.

Other College Savings Options

A high-yield savings account may be a good fit in certain circumstances, but it's a good idea to research and compare several different ways you can pay for college to determine which one is the best fit for you.

529 Plan

A 529 college savings plan is a tax-advantaged savings account that allows you to invest your contributions. Both gains and distributions are tax-free, as long as you use your funds for qualified educational expenses. Additionally, some states offer tax benefits to people who contribute.

That said, if you use your 529 plan funds for non-qualified expenses, you may be subject to income taxes on the investment gains plus a 10% penalty.

Coverdell ESA

A Coverdell education savings account operates similarly to a 529 plan, offering investment options with tax-free growth and withdrawals for eligible expenses. But unlike 529 plans, which don't have annual contribution limits, you can only put $2,000 per student in a Coverdell ESA each year.

Additionally, contributions don't qualify for federal or state tax benefits.

Custodial Accounts

Uniform Transfers to Minors Act (UTMA) and Uniform Gifts to Minors Act (UGMA) accounts are custodial accounts that you can use to save for your child's college costs. While your child is a minor, you can use the funds to cover any expenses for their benefit. Once they reach the age of majority—either 18 or 21, depending on the state—the funds belong to them.

When it comes to financial aid, though, UTMA and UGMA account funds are counted as the student's assets, which can reduce their eligibility for federal financial aid. They also don't offer any of the tax benefits that you'd get with a 529 plan or Coverdell ESA.

Roth IRA

A Roth IRA is technically a retirement account, allowing you to contribute up to $6,500 in 2023, but it can also be used for college expenses. That's because you can withdraw your contributions without any penalties, and you can also avoid the standard 10% penalty for early withdrawals if you use those funds for qualified educational expenses.

That said, you'll still need to pay taxes on any gains you withdraw from your Roth IRA for college costs. Also, not everyone can contribute to a Roth IRA: Your income must be below a certain threshold to qualify. Finally, if you use a Roth IRA for college expenses, it could limit your options for saving for your own retirement.

When Should You Start Saving for College?

It's best to start saving for college as soon as possible. Some parents open an account soon after their child's birth. Even if you can only muster a small contribution each month, those small savings can add up over the course of 18 or more years.

If you didn't have the option to start early, however, the best time to start saving for college is now. Depending on how long you have until you or your child starts school, you may be able to use savings to cover a significant portion of tuition and other college expenses.

That said, it's important to make sure your own financial plan is solid before you start saving for college. Review your retirement plan, emergency fund and other crucial financial goals to determine whether you can afford to focus your efforts on college savings.

The Bottom Line

Saving for college can be a great way to reduce reliance on student loans and to avoid stretching your finances thin, but you may be overwhelmed with all the different options you have to accomplish that goal. Whether you're considering a high-yield savings account, 529 plan or something else, take your time to research and understand the advantages and disadvantages of each option to determine which one is best for you.