College Savings Plans

As student loan debt climbed past the $1.4 trillion mark in 2016, and the cost of college continues to soar, finding ways to pay for higher education is on the minds of parents and guardians across the nation.

Only two out of every five families have a college savings plan in place to alleviate the high cost of education.

A recent study found that families with a college savings account borrowed one-third less to pay for college, while parents and students who plan for the cost of college save 46% more than those who don’t.

College savings plans also broaden the range of schools a student may choose to attend when financial considerations aren’t the deciding factor. Given that cost is the third biggest issue when deciding which college to attend, finding ways to lessen the financial burden is of paramount importance in today’s economy. The last decade has produced countless stories of students graduating with the world at their feet before succumbing to crippling student debt and outrageous interest rates, but this doesn’t have to be the case.

Although it is never too early to start saving, it’s also never too late. There are a range of college savings plans available, and this guide exists to provide clarity about the differences and similarities among them and walk families through the process of deciding which option is best for their needs. Keep reading to learn how you can ease the anxiety of financing a college education.


Types of College Savings Plans

529 Plans and the Coverdell ESA

The Coverdell educational savings account, 529 Prepaid Tuition, and 529 College Savings plans are consistently the most popular among families. Why? Each plan allows for tax-deferred earnings throughout the lifetime of the account, and earnings are tax-free if used for qualified educational costs. Keep reading to learn about some of the other key similarities and differences between these plans.

Breakdown of 529 Plans and Coverdell
  529 College Savings 529 Prepaid Tuition Coverdell ESA
Age Limit No limit No limit Under 18
Contribution Limit Varies; most allow an excess of $250,000 per beneficiary Amount is fixed by the terms of specific contracts $2,000 Annually
Federal Tax Benefits Tax-deferred earnings; tax-free if used for education Tax-deferred earnings; tax-free if used for education Tax-deferred earnings; tax-free if used for education
State Tax Benefits Depends on the state. Some offer deductions for contributions, tax-free earnings, or tax-free withdrawals for education Depends on the state. Some offer deductions for contributions, tax-free earnings, or tax-free withdrawals for education None
State Tax Benefits Depends on the state. Some offer deductions for contributions, tax-free earnings, or tax-free withdrawals for education Depends on the state. Some offer deductions for contributions, tax-free earnings, or tax-free withdrawals for education None
Income Phase-Out None None Single: $95,000-110,000; Joint: $190,000-220,000
Penalties Earnings taxed at normal income rate; could be subject to 10% withdrawal penalty Earnings taxed at normal income rate; could be subject to 10% withdrawal penalty Withdrawals exceeding educational costs of the beneficiary may be taxed

UGMA/UTMA

The Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) are two types of custodial accounts that allow the transfer of assets to a trust. Because minors do not have the right to contract or own property, donors – most often parents or guardians – can transfer funds to the trust and make their child the beneficiary once they reach adulthood. These are typically considered a favorable option for wealthier families because there are no limitations on contributions, and custodians have the right to invest the accounts into different types of investment funds.


Pros

  • Although income from a UGMA/UTMA account is taxable, the Kiddie Tax rules allowing for taxation at the child’s rate typically means less has to be paid than if it were part of the parent or donor’s taxable income.
  • Unlike 529 college savings plans and the Coverdell which only allow for bank deposits, the UTMA account states that any type of asset – such as real estate – can be transferred to the minor beneficiary.
  • Before the creation of UGMA/UTMA accounts, there was no way to transfer assets or securities to a minor without paying for a lawyer to create a special trust to hold the assets until adulthood. These custodial accounts eliminate the needs for this extra expense.

Cons

  • Unlike 529 savings plans or the Coverdell ESA, income from custodial accounts are still taxable.
  • Although many UTMA/UGMA accounts are created for the purpose of providing educational funds to a minor, there is no provision in this type of custodial account that states the beneficiary must use the money for education.
  • The government views a custodial account as an asset of the beneficiary, meaning the income can greatly impact how much financial aid a student is able to receive. 529 savings plans and Coverdell ESAs, conversely, are typically owned by a third party and are not reported as income on the FAFSA.

Investment Accounts

While unexpected last-minute costs may necessitate dipping into an investment accounts, using them to finance a college education is ill-advised. As you’ll see, the majority of investment funds have tight restrictions on when the money can be removed and impose penalties when investors violate the rules. Most of the funds pulled from these accounts constitute income. Therefore, families must also consider the very real issue of financial aid packages being greatly reduced because of perceived higher incomes reported on the FAFSA. Review the table to learn more about the issues of using investment accounts for college fees.

Breakdown of Investment Types
  Roth IRA Mutual Funds 401k
General Purpose Contributors pay taxes on the initial amount, while distributions are tax-free Comprised of investments from many different contributors, with the overarching goal of investing large amounts of capital in different stocks, bonds, and money market vehicles to produce capital gains Established by employers, employees can contribute portions of their salary, either pre- or post-tax, with the possibility of matched funds from their company
Educational Perks Aren’t considered an asset for the FAFSA, can be used for a wider range of educational expenses Lower administrative fees than other college savings plans; can produce higher returns than 529 plans Some 401(k) plans allow owners to borrow funds without penalty, provided they are repaid within five years
Downsides Non-qualified distributions from the Roth IRA are penalized; owner must be at least 59.5 years of age, or they will incur a penalty End-of-year capital gains disbursements are taxable and appear as assets on the FAFSA; mutual fund managers make investment decisions based on tax consequences rather than investment potential, unlike plans created specifically for college savings Created to assist with retirement; funds used for education are siphoned from the parents’ retirement. Funds removed before the owner is 59.5 are also subject to a 10% penalty; funds withdrawn also constitute income, which decreases the amount of aid provided through FAFSA

AffordableCollege.com’s Recommended College Savings Plan

After reviewing information about the range of college savings plans available, our recommendation for the best college savings plan is the 529 plan. All 50 states now offer at least one 529 plan – either the college saving or prepaid tuition plan – but families can also use a different state’s plan if their preferred option isn’t available. The advantages of this plan include a higher contribution ceiling, federal and state tax advantages, lower impact on financial aid packages, and the flexibility to pick the best investment portfolio for college savings.

While the Coverdell ESA is attractive to families who want to save money for grade school education, the $2,000 per year contribution ceiling ultimately makes this plan less flexible and more limiting. The UGMA/UTMA plans also come with major drawbacks. Although these custodial accounts allow minors to access funds set aside for them in a trust, they offer no tax benefits. They can also massively affect financial aid packages in a negative way.

After considering all the options, weighing pros and cons, and seeking the guidance of qualified experts, there’s no question: our money is on the 529 plan.


Resources

  • IRS Information on Coverdell Education Savings Account The Internal Revenue Service provides this extensive guide on how Coverdell ESAs work, including information about contribution limits, penalties, transfers, distributions, and tax benefits.
  • FINRA Information on 529 Plans The Financial Industry Regulatory Authority offers guidance on the differences between 529 college savings and prepaid tuition plans alongside other helpful tools for better understanding college savings.
  • Example UGMA/UTMA Custodial Account Agreement The Utah Educational Savings Plan offers an example of the agreement custodians complete to set up a UGMA or UTMA account for a beneficiary.
  • College Savings Calculator College Board maintains this free tool to help families learn about annual college costs and inflation rates to help them determine how much money they should be saving to cover a percentage or total amount of a college education.
  • SEC Introduction to 529 Plans The U.S. Securities and Exchange Commission has compiled a range of research, reports, publications, and resources to help families understand how to best save for college.