When you are looking to save for college, it is easy to find yourself mired in an alphabet soup of options — ESAs, 529s, UGMAs, UTMAs, and IRAs.
But each of these options comes with a unique set of advantages and disadvantages you will want to know upfront. Choosing the right way to save can mean significant tax savings and an easier path to covering college costs.
So it’s essential to weigh the Pros and Cons of these five financial plans and savings accounts:
529 Plan: Education Savings Plan
HOW IT WORKS
Education savings plans are one of the two types of 529 plans. Any adult can open one through a state’s 529 plan. The account owner controls the assets in the plan and can designate or change the beneficiary of the funds.
Using a 529 plan is straightforward. Plan owners choose from the investments offered in the plan and contribute money to the account. The money grows over time, according to changes in the market. Then, when college expenses arise, funds are withdrawn to cover the costs.
A 529 plan is one of the most popular college savings tools with good reason, as there are many advantages of using one.
Tax benefits are key. Though contributions are taxed federally, 34 states offer deductions. And the IRS offers tax-free growth and withdrawals to everyone. So the money your investments earn is never taxed, provided you use your withdrawals for one of many qualified educational expenses (like tuition, fees, room & board, and books).
The amount you can contribute varies by state, but the minimum is a hefty lifetime cap of $235,000. Your own state may offer tax incentives for using its 529 plan, but you are free to choose any state’s plan. And, as the account owner, you can change the beneficiary to any qualified relative.
But 529 plans aren’t just for college anymore. Effective in 2018, the Tax Cuts and Jobs Act now allows plan owners to withdraw up to $10,000 each year for K-12 tuition bills.
The 529 plan currently does not offer any federal tax deduction for contributions, and many states do not provide this break either.
Additionally, beneficiaries cannot use plan funds for some college expenses—health insurance, transportation, extracurricular activities, and room & board costs for some part-time students. Those covering K-12 expenses are limited to tuition only. And any money withdrawn for non-qualified expenses is subjected to both income tax and a 10% penalty.
Plans are available in every state, but you’re typically limited to just a handful of asset choices within a given plan.
529 Plan: Prepaid Tuition Plan
HOW IT WORKS
Your second option when opening a 529 plan is to choose a prepaid tuition plan. Rather than investing your money in this plan, you pay—at today’s rates—for college credits. Then, when the beneficiary is ready to attend, you receive the benefit of those paid-for credits.
As with education savings plans, most states offer tax deductions for contributions made to prepaid tuition plans. Unlike investment plans or accounts, prepaid plans offer no market risk. So you are guaranteed to receive the benefit of the money you contribute.
At present, just 10 states offer prepaid tuition plans. The credits you purchase can be used at only a subset of schools—generally community colleges and in-state schools. Lifetime contribution limits vary, but they typically fall under six figures (in line with the cost of a 4-year state school).
As with education savings plans, there is no federal tax break for contributions to these plans, and some states do not offer deductions.
Coverdell Education Savings Account
HOW IT WORKS
The Coverdell Education Savings Account (ESA) predates the 529 plan and has a number of similarities. After opening an account, you contribute money, invest the funds, watch your assets grow according to market changes, and make withdrawals for eligible college expenses.
Money in a Coverdell ESA enjoys tax-free growth and tax-free withdrawal of funds. The interest and dividends you earn are never taxed, provided you use the cash for qualified expenses.
Where a 529 plan has just a few investment choices, Coverdell ESAs offer a wide variety of assets from which to choose, including (but not limited to) stocks, bonds, ETFs, and mutual funds.
Account owners have much greater flexibility when it comes to K-12 expenses. Instead of covering just tuition, withdrawals may apply to fees, uniforms, books, school supplies, and more. And there is no cap on how much you can withdraw to cover qualified costs.
The largest limitation with Coverdell ESAs is the tight restriction on contributions. All accounts for the same beneficiary can receive contributions of just $2,000 each year. And those with high incomes may be limited or excluded from contributing at all. Additionally, there’s typically no state tax deduction for contributions or earnings from a Coverdell ESA.
While 529 plans can be used for students of any age, Coverdell ESAs must be established while the beneficiary is a minor. Funds must be transferred to another qualified beneficiary or used before the existing beneficiary turns 30.
UGMA or UTMA
HOW IT WORKS
Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts are custodial investment accounts. Assets in the account belong to a minor but are controlled by the named custodian until the child reaches adulthood.
UGMAs and UTMAs are largely similar, with a few notable differences. Both types of accounts are offered by a number of financial institutions, including banks, credit unions, and brokerage firms.
With a UGMA or UTMA, the custodian makes contributions to the account and invests the funds in one or more assets. Contributions, buying and selling of investments, and withdrawals may be completed at any time.
UGMAs and UTMAs offer a great deal of flexibility. There’s no limit to the size of contributions or withdrawals. And you can use the funds for any purpose without penalty. So investments may be sold to pay for college, buy a home, pay for clothes — anything that benefits the minor.
The assets in the UGMA/UTMA are considered the property of the minor. As a result, gains earned in the account are taxed at the child’s tax rate, which is usually lower than that of the parents.
Beyond being taxed at the minor’s tax rate, there’s no tax advantage to a UGMA or UTMA. Contributions are made with after-tax earnings. Dividends and interest are taxed during the current tax year. And withdrawals see no federal or state tax deduction.
Contributions to a UGMA/UTMA are irrevocable. Even if you opened the account and control the assets for the minor, the funds are the property of the child. Consequently, you can’t move the money from one child to another, and all withdrawals must benefit the named minor directly.
Furthermore, once the minor reaches adulthood, he or she receives full control over the assets. So that child is free to use the cash for college as you intended or another purpose entirely.
Finally, keep in mind that child assets are weighted more heavily than those of parents in calculating your Expected Family Contribution (EFC). As a result, UGMA/UTMA funds can translate to lower financial aid offers than funds that are kept in parent assets (like a 529 plan or Coverdell ESA).
HOW IT WORKS
Individual retirement accounts (IRAs), Roth IRAs, and retirement plans like 401(k)s are used to save and invest money, so the assets can be tapped as income after retirement. Some families, however, may look to withdraw part or all of their retirement fund balance to pay for college costs.
In most cases, withdrawing funds from a traditional or Roth IRA before age 59.5 comes with a penalty. But there are a few exceptions to that rule. One way to bypass the sizable 10% penalty is to utilize distributions to cover qualifying college costs. (The rules for a 401(k) are a bit different.)
With a Roth IRA, your contributions have already been taxed. So you are free to withdraw the amount you contributed—just not the earnings—for any reason and at any age.
Retirement accounts and employer-sponsored plans were not designed to pay for college expenses, so there are numerous downsides.
The first is the problematic mixing of investment goals when you are using an account for both retirement and college savings. Retirement is generally much farther off than your child’s college years. So the investments you choose to meet retirement goals are not necessarily the same ones you would select with the shorter time horizon of college.
Second, you are limited in how much you can contribute. In 2020, an individual could contribute just $6,000 (or $7,000 if you are age 50 or older) to all IRAs in his/her name. And, once you pull that money out, you cannot refill it later with extra cash to cover retirement.
Third, the money held in retirement accounts is not counted toward your family’s assets when you complete the FAFSA. But, when you withdraw the funds to pay for college, those distributions are counted as income. And that income can reduce the size of your financial aid package.
Fourth, there are many options—including loans—for covering your college costs. But there are no loans for retirement. In most cases, you’re better off dealing with college expenses in a way that doesn’t involve tapping your retirement accounts.
Finally, most 401(k) plans do not allow you to skirt the 10% penalty for higher-education costs. Withdrawing money from IRAs to pay for school can be tricky. So you will want to work with a financial advisor or tax professional before you head down that path.
There are plenty of options for when you want to save for college. By knowing how each plan or account operates, you can choose the method that works best with your family’s unique financial goals.