College Savings Options

In the past few years, student loan debt has become a hot topic as the average debt per student continues to climb to all new highs.  According to the credit reporting agency Experian, the average amount of student loan debt per borrower in 2019 is $35,359.  Additionally, 10.8% ($152 billion) of the total student loan debt ($1.41 trillion) is at least 90 days past due or in default.  Given these statistics, I’m not surprised so many parents regularly ask me questions about education planning. The most common questions are “how much do I need to save for college?” and “which accounts should I be using?”.  This article will focus on the second part of that question by discussing the college savings accounts available and the advantages and disadvantages of each type.

Before we dive into the specific types of college savings accounts, let’s briefly address the question, “how much do I need to save?”. The amount needed is dependent on a few variables such as the child’s age, the amount saved to date, outside contributions (inheritance, monetary gifts etc.), and whether the money is intended only for college expenses or private schooling for K-12.  The required monthly or annual contributions are then calculated using compounding interest.  My May 2019 article discusses the effect of compounding interest and the article includes a table of projected growth over various time frames given different monthly dollar amounts.  Once the required contributions are determined, the next step is to determine which accounts will be used for education planning.

There are currently four main options for college savings:

1. Coverdell Educational Savings Account (ESA)

2. 529 Plan

3. UTMA/UGMA

4. Brokerage account

The remainder of this article will break down the advantages and disadvantages of each account type to help families make an informed decision as to which account best fits their educational savings goals.

Coverdell Education Savings Account (ESA)

A Coverdell ESA is a custodial account managed by the parent or adult that is designated to pay qualified educational expenses for the beneficiary listed on the account.  The Coverdell ESA allows an individual to contribute up to $2,000 after tax per beneficiary, per year.  Here are the advantages and disadvantages of a Coverdell ESA:

Advantages

1. The money contributed grows tax deferred and is tax free upon withdrawal if the funds are used to pay for K-12 or higher education qualified expenses. (The IRS is specific as to which educational expenses are considered qualified. Here is the IRS link with the information.)

2. A variety of investment options as the account can be opened with almost any investment company.

3. The beneficiary on the account can be changed to another family member if the full balance is not used.

Disadvantages

1. Contributions are limited to $2,000 per year.

2. No federal or state income tax deduction for contributions.

3. Income limits apply when making a Coverdell ESA contribution. Contributions are not allowed for married individuals with adjusted gross income over $220,000 or single individuals with adjusted gross income over $110,000.

4. The balance must be used, or the balance transferred to another beneficiary by age 30.

5. The balance must be used for qualified educational expenses or an IRS penalty will be incurred on the earnings of the account.

529 Plan

A 529 Plan is like a Coverdell ESA in many ways; however, there are a few key differences.  Like a Coverdell ESA, a 529 plan is a custodial account managed by the parent or adult designated to pay qualified educational expenses for the beneficiary.  529 Plans differ in that they are established and maintained by each state individually, so the tax benefits and investment options are different for each state.  In addition, a 529 plan has much higher contribution limits per year and typically has no income limitations for making contributions. Here are the advantages and disadvantages of a 529 Plan:

Advantages

1. The money contributed grows tax deferred and is tax free upon withdrawal if the funds are used to pay for K-12 or higher education qualified expenses.

2. Most states offer a state income tax deduction on annual contributions up to a certain limit. For example, in the state of Illinois, 529 plan contributions are deductible up to $10,000 per year as an individual or $20,000 per year if married.

3. No income limits for making a 529 plan contribution.

4. Can contribute as much as $70,000 in one year to a 529 plan without being affected by gift tax consequences. That amount is doubled to $140,000 for a married couple.  Keep in mind that if an individual makes a large contribution in one year, only a certain portion of the contribution will be state income tax deductible.

5. No age-based restrictions.

6. Beneficiary on the account can be changed to another family member if the full balance is not used.

Disadvantages

1. Investment options are limited according to the State’s 529 plan provider. Typically, investment options only include index or mutual funds.

2. Fees may be higher in a 529 plan

3. There may be tax consequences if individuals move to another state and want to transfer their current 529 plan funds to the new state’s 529 plan.

4. The balance must be used for qualified educational expenses or an IRS penalty will be incurred on the earnings of the account.

UTMA/UGMA

An UTMA/UGMA account is a custodial account which is set-up and managed by the parent or adult on behalf of the beneficiary.  The state the individual opens the account will determine whether the account is called an UTMA or UGMA.  The rules for the two types of accounts are basically the same.  UTMA/UGMA accounts differ from Coverdell ESA and 529 plans in that the balance can be used for any expense the beneficiary incurs rather than just qualified educational expenses. However, one potential downside of this type of account is that when the beneficiary turns 18 or 21 (depending on the state), the account ownership is legally transferred from the adult to the beneficiary. With that transfer, the beneficiary can choose to do whatever they want with the money.  Here are the advantages and disadvantages of a UTMA/UGMA:

Advantages

1. The balance can be used on expenses other than just qualified educational expenses.

2. No income or contribution limits.

3. Small tax advantage to the parent as the first $2,100 in unearned income each year is not taxable to the beneficiary or the parent.

4. Variety of investment options as the account can be opened with almost any investment company.

Disadvantages

1. Beneficiary can use money however they choose when they turn legal age (18 or 21 depending on state).

2. Beneficiary can’t be changed after the account is opened.

3. UTMA/UGMA balances are counted as a student asset instead of parent asset on the FAFSA so financial aid could be decreased as compared to a Coverdell ESA or 529 plan.

4. No federal or state income tax deductions for contributions.

5. No tax deferred or tax-free growth.

Brokerage Account

A brokerage account is significantly different from the other three types that have been discussed.  The account is opened by the parent or adult and the balance of the account can be used for any purpose. There are no tax advantages to using this type of account; however, the main advantage it has over the other types of accounts is flexibility.  Here are the advantages and disadvantages of a brokerage account:

Advantages

1. The balance can be used on any expense providing complete flexibility. For example, the account can be used for education, a first car, a down payment on a home, weddings, etc.

2. Complete flexibility as to when the money is given to the beneficiary and on what terms.

3. No income or contribution limits.

4. Variety of investment options as the account can be opened with almost any investment company.

Disadvantages

1. No tax advantages

2. If the account grows substantially, there may be gift tax consequences when the balance is given to or transferred to the child.

Conclusion

There are many account options available for families looking to save for education.  Each of these account options can make sense in certain situations depending on the goals that have been established.  If you want to discuss which type of account is the best fit for your educational savings goals, please use my scheduling link to book an appointment.