There are many different ways that you can save for a college education. Whether you are saving for your children or grandchildren, it is essential to understand the various options available to you to establish a college savings account, and the pros and cons of each.
This ultimate guide to college savings accounts will help you understand 529 plans, Coverdell accounts, custodial accounts, and more!
A 529 plan is one of the most popular ways to save for education expenses. It is a tax-advantaged savings option that can be used for both college and K-12 tuition.
There are two primary types of 529 plans: prepaid tuition plans and college savings plans.
A prepaid tuition plan allows you to prepay all or a portion of the tuition to an in-state public college. Most plans allow for these funds to be converted for use at out-of-state and private institutions as well.
The college savings plan is very similar to a Roth IRA and involves investing after-tax dollars into mutual funds or other investments that grow tax-free. Unlike the prepaid tuition plan that has a fixed value, these accounts will fluctuate depending on the performance of the underlying investments.
Every state has a 529 plan, and you are not limited to only investing with your own state. You are also not locked into a specific college or educational institution based on the 529 plan you choose.
Benefits of a 529 Plan
The primary benefit to a 529 plan is that the money saved in these accounts grows tax-free if the funds are used for education expenses. Some states will also offer a state income tax deduction for contributions to their state 529 plans.
The tax-free withdrawals can be used for qualified higher education expenses and a maximum of $10,000 annually for K-12 tuition.
529 plan contributions are considered taxable gifts to the beneficiary. With this in mind, you can front-load the $15,000 annual gift-exclusion amount in the first year up to $75,000. This allows you to shelter a larger amount of tax-free education funds early on. Depending on the plan, your maximum balance can exceed $500,000, and you can save up to $15,000 each year – per individual – to qualify for the gift tax exclusion.
If the 529 account is opened up in the parent’s name, the students will also receive favorable financial aid treatment. The account is considered an asset of the parents, so they do not have to report it on the Free Application for Federal Student Aid (FAFSA) when the funds are used to pay for tuition.
Qualified expenses under a 529 plan include tuition and fees, room and board if students are enrolled a minimum of half-time, books, materials, and other relevant computer equipment. The SECURE Act also allowed for up to $10,000 of tax-free distributions to pay off student loans.
The funds can be used for rent or room and board but cannot exceed the amount charged by the college. If the student lives off-campus, this amount is determined by the college’s cost of attendance figures.
You can distribute funds from this account directly to the account holder, school, or beneficiary.
Drawbacks to a 529 Plan
The drawbacks of choosing a 529 plan include the fact that you will pay a 10% penalty, plus income taxes on growth in the account if the withdrawn funds are not used for qualified education expenses. In addition, if you make a withdrawal from an account owned by someone that is not a parent or the student, it will be added back to their income and must be reported on the FAFSA. This can reduce eligibility for financial aid up to 50% of the distribution amount.
Likewise, the investment strategies in these accounts are limited to what is offered by each state’s plan.
Coverdell Education Savings Accounts
A Coverdell Education Savings Account, or ESA, is another college savings option that allows you to direct the investments yourself. They provide tax-free withdrawals if the funds are used for K-12 or higher education expenses, and the account will be counted as the parent’s asset on the FAFSA application.
The main advantage of a Coverdell ESA is that withdrawals used for qualified education expenses are federal tax-free. You also have more freedom to choose the type of investments held within the account, and you can direct them yourself.
If you need to change the beneficiary, you can do so without penalty, but only if certain conditions are met.
The downside to Coverdell ESAs is that you can only contribute $2,000 each year. This limit can decrease further based on your modified adjusted gross income. If you are single and earn more than $110,000 or if you are married and earn a combined income of over $220,000, you cannot contribute to this account.
This low contribution limit can be a problem if you have multiple children or beneficiaries – or if you need to save a substantial amount for a private university or other expensive educational institution.
Similarly, you can no longer make contributions after the beneficiary turns 18 years old unless they have special needs. If the funds are not used by age 30 and the beneficiary does not have special needs, the account must be closed. Most Coverdell ESAs require a fee to open or maintain the account as well.
Any withdrawals that are made for things other than qualified education expenses are not only taxed but also subject to a 10% federal penalty on the growth in the account.
A custodial account is a savings vehicle that is opened by someone on behalf of a minor. Although someone else opens the account the minor is the legal owner.
Once you set up the account, it operates like any other financial services account. The custodian is a fiduciary that is responsible for making investment decisions, and almost anyone can contribute to the account on the minor’s behalf.
There are age limits that vary by state and can range from 18 to 24. Once the minor reaches the legal age of adulthood in that state, they become the owner and custodian of the account. At this point, he or she can direct the investments however they see fit – meaning they can use it to fund their college education, buy a new car, or travel the world. No one can keep them from using the funds for whatever it is they choose.
There are two types of custodial accounts: UGMA and UTMA.
UGMA stands for Uniform Gifts to Minors Act. These accounts can hold basic investments such as stocks, bonds, insurance-related products, and mutual funds.
The other option, UTMA, or Uniform Transfers to Minors Act, is the most common form of a custodial account. These accounts have superseded UGMAs in every state except for Vermont and South Carolina. With this account type, you can invest in a broad range of securities like stocks, bonds, and mutual funds, as well as real estate and collectibles.
Regardless of whether you open a UTMA or UGMA account to save for college expenses, the financial institution will not allow you to engage in high-risk investment strategies. This means you will not be able to buy and sell on margin or invest in derivatives, commodities, futures, or options.
Advantages of a Custodial Account
A custodial account has many advantages when it comes to college savings, including the fact that no rules govern how much can be contributed. You can invest as much as you would like each year, and anyone like friends and family can contribute to the account with no limits. However, it is necessary to note that gift taxes may apply if you exceed the annual exclusion limits.
This extensive freedom also includes the ability to use the funds however you wish. Students can utilize the money for tuition, room and board, laptops, dorm furniture, clothing, or anything that the custodian can show is benefitting the minor.
Once the beneficiary reaches the age of majority, the account becomes theirs and he or she can choose how to spend the funds!
It is also easy to open a UTMA or UGMA account, and typically all it requires is visiting a financial institution to set one up.
There are also some benefits on how unearned income in a custodial account is taxed.
Disadvantages of a Custodial Account
The funds available in a custodial account can negatively impact college funding, so it is essential to keep this in mind before you establish one. Since the custodial account legally belongs to the beneficiary, it is seen as assets available to them and can cause colleges to limit the financial aid they offer.
When compared to college savings held in a 529 plan or Coverdell ESA, this negative impact weighs much more heavily when it comes to the student’s ability to receive financial aid. The maximum reduction for assets in a 529 plan owned by a student is 5.64%, but UTMA funds can reduce your eligibility by 20% to 25% of the value of the account.
Another disadvantage is that there is no tax advantage to saving for college through a custodial account. Unlike the ones we discussed previously, which allow for tax-free earnings and withdrawals if used for higher education expenses, a custodial account will be subject to federal income tax.
Likewise, once you establish an account, you cannot change the beneficiary. This limitation means if your child or grandchild decides not to go to college or continue their education, they will still receive the funds. Furthermore, once they reach the age of majority, there are no restrictions on how they can spend the funds!
That means that they have the right to spend all of the money you worked hard to save for their education on anything they want, even if it is not a sound financial decision.
Qualified U.S. Savings Bonds
Qualified U.S. Savings Bonds are a series of EE bonds that were issued after 1989, or Series I Bonds. To use these to save for college, they must be issued in your name or as a co-owner with your spouse. Likewise, you have to be at least 24 years old before the bond’s issue date.
Benefits of Qualified U.S. Savings Bonds
These savings bonds are both state and federal tax-free. They can be redeemed for qualifying higher education expenses, and the interest-earning bonds the owners are invested in are backed by the full faith and credit of the U.S. government.
Downsides to Qualified U.S. Savings Bonds
Although you can redeem investments these tax-free when used for college expenses, you can only invest $10,000 per year. This limit applies to each owner, per type of bond.
Similarly, there is an income limit where the interest exclusions begin to phase out. In other words, if you earn too much, you will not be able to benefit from tax-free interest. If you do not use the proceeds from the bonds to pay tuition or other education expenses, the interest will be subject to federal income tax.
So, Which Option is Best?
Now that you understand the various college savings account options available, you may be wondering which choice is right for your situation. Do you choose a 529 plan or a custodial account? Or perhaps a Coverdell ESA is the better option?
Although each of the account types we discussed provides certain benefits, many parents opt for regular brokerage accounts in their own name. This ultimately gives them the most flexibility and freedom regarding when and how to utilize the funds.
With a brokerage account, you may spend the money on college tuition or anything else – if your children, or grandchildren, decide they don’t want or need the funds, you don’t have to pay a penalty to use them elsewhere.
With the changing landscape of higher education driven by the global COVID-19 pandemic, it is impossible to predict what college – and tuition – will look like in 5 years, let alone 15+. For this reason, a simple brokerage account that is not specific to education savings may make a lot more sense. And give you more flexibility and control.
It is important to note, though, that this approach to saving for college needs to be managed in a tax-efficient manner. The best way to do this is to partner with a financial advisor that also offers tax planning so they can guide you every step of the way!