College Savings Options

Saving for education has become an increasingly important topic for families as college costs continue to rise. Many parents ask, “How much do I need to save for college?” and “Which accounts should I use?” This article focuses on the second question, discussing college savings accounts and the advantages and disadvantages of each type.

How Much Should You Save?

The amount needed depends on a few variables, such as the child’s age, how much has already been saved, outside contributions (inheritances, monetary gifts, etc.), and whether the funds are intended only for college or also for K-12 education. Required monthly or annual contributions are calculated using compounding interest. Once these contributions are determined, the next step is choosing the account type that best fits your education savings plan.

Four Main College Savings Options

1. Coverdell Educational Savings Account (ESA)

2. 529 Plan

3. UTMA/UGMA

4. Brokerage account

The remainder of this article breaks down the advantages and disadvantages of each account type to help families make an informed decision.

Coverdell Educational Savings Account (ESA)

A Coverdell ESA is a custodial account managed by a parent or designated adult to pay qualified educational expenses for the beneficiary.

Advantages

1. Contributions grow tax-deferred, and withdrawals are tax-free when used for K-12 or higher education expenses

2. Wide variety of investment options

3. The beneficiary can be changed to another family member if the funds are unused

Disadvantages

1. Annual contribution limits

2. No federal or state income tax deduction for contributions

3. Income limits apply (e.g., contributions not allowed for high-income individuals)

4. Funds must be used or transferred by age 30

5. IRS penalties apply if funds are not used for qualified education

529 Plan

529 Plans are state-sponsored accounts designed to pay for qualified educational expenses. Contribution limits are higher than Coverdell ESAs, and income restrictions typically do not apply.

Advantages

1. Contributions grow tax-deferred, and withdrawals are tax-free for qualified expenses

2. Many states offer a state income tax deduction on contributions

3. High contribution limits with potential gift-tax benefits

4. No age restrictions

5. The beneficiary can be changed to another family member

Disadvantages

1. Investment options are typically limited to index or mutual funds

2. Fees may be higher than other accounts

3. Tax consequences may occur when transferring funds to another state’s plan

4. IRS penalties apply if funds are not used for qualified education

UTMA/UGMA Accounts

UTMA/UGMA accounts are custodial accounts where funds can be used for any expense the beneficiary incurs. The account transfers to the beneficiary when they reach legal age (18 or 21, depending on the state).

Advantages

1. Funds can be used for education or any other purpose

2. No income or contribution limits

3. Small tax advantage for the first portion of unearned income

4. Variety of investment options

Disadvantages

1. Beneficiary gains control at legal age and may use funds as they choose

2. Account ownership cannot be changed after opening

3. Counts as a student asset on FAFSA, which may reduce financial aid

4. No tax-deferred growth or deductions for contributions

Brokerage Account

A brokerage account is significantly different from the other three types discussed. It is opened by a parent or adult, and the balance 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. 

Advantages

1. Funds can be used for any purpose (education, car, down payment, wedding, etc.)

2. Flexible timing and distribution

3. No income or contribution limits

4. Wide range of investment options

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 for families looking to save for education. Each type can make sense depending on goals, timeline, and financial circumstances. To determine which account is the best fit for your family’s education savings plan, call us today.