What Account Should I Use To Save For College?
The cost of college has risen rapidly over the last few decades and many families are wrestling with how to pay for it. And ideally, if your kids are young, how to save for it. This article is going to focus on the different accounts you can use to save for college. And the good news is, most of these will help you pay for many post-secondary education options such as vocational schools.
Each account has some advantages and disadvantages in regards to paying for education, so lets get into it!
1. 529 Plans
The 529 plan is usually the first account people think of when it comes to saving for college. There is good reason for it, for most people it will be the most efficient way to save for school. However the does not mean it is necessary the best account for you.
Advantages:
Tax Benefits: Earnings grow tax-free and withdrawals for qualified education expenses are tax-free.
High Contribution Limits: Most plans allow large contributions, often over $400,000 total for the beneficiary. However, it usually makes sense to fund it over time with contributions that are under the annual gifting limit(In 2024 it is 18,000 for a person who files singly and $36,000 for a couple that files jointly).
No Income Limits: There are no income restrictions on individual contributions.
State Tax Benefits: Many states offer tax deductions or credits for contributions.
Flexibility: Funds can be used for tuition, fees, books, room and board. The funds can often be used for K-12 education and other post-secondary education such as vocational schools, tech schools, etc.
Transferability: Funds can be transferred to another beneficiary if the original beneficiary doesn’t need the funds.
Disadvantages:
Limited Investment Choices: Investment options are typically limited to what the plan offers. And since 529’s are sponsored by states and work with different financial companies, the investment options can have some significant differences across the various plans.
Penalties for Non-Qualified Withdrawals: Earnings on non-qualified withdrawals are subject to income tax and a 10% penalty.
Potential State Tax Recapture: If you received a state tax deduction or credit, you may have to pay it back if you make non-qualified withdrawals.
2. Coverdell Education Savings Accounts (ESAs)
This account is far less common than the 529 but is the only other account that is specifically designed to save for education expenses.
Advantages:
Tax Benefits: Earnings grow tax-free and withdrawals for qualified education expenses are tax-free.
Broad Range of Investment Options: ESAs offer more flexibility in choosing investments compared to 529 plans.
Use for K-12 Expenses: Funds can be used for both K-12 and higher education expenses.
Disadvantages:
Contribution Limits: Annual contribution limit is $2,000 from all sources per beneficiary.
Income Limits: Contributions phase out at higher income levels.
Age Limits: Contributions cannot be made after the beneficiary turns 18, and funds must be used by age 30 (unless the beneficiary has special needs).
3. Custodial Accounts (UGMA/UTMA)
Advantages:
Flexibility: Funds can be used for any purpose that benefits the child, not just education.
No Income or Contribution Limits: There are not limits to can be contributed to the account and there are no income limits that restrict who can contribute.
Variety of Investments: A wide range of investment options is available.
Control Transfer: The child gains control of the account at the age of majority (usually 18 or 21).
Disadvantages:
Impact on Financial Aid: Assets in custodial accounts are considered the child’s and can significantly impact financial aid eligibility.
No Tax Benefits: Earnings are subject to taxes. The first $1,100 is tax-free, the next $1,100 is taxed at the child’s rate, and amounts over $2,200 are taxed at the parents’ rate.
Irrevocable Gifts: Contributions are considered irrevocable gifts to the child.
4. Taxable Investment Accounts
Advantages:
Flexibility: Funds can be used for any purpose.
Control: Parents retain control so any money not used for education can be used for any other financial goals the parents might have.
No Contribution Limits: Unlimited contributions.
Variety of Investments: A wide range of investment options is available.
Disadvantages:
No Tax Benefits: Earnings are subject to taxes.
Impact on Financial Aid: Considered in financial aid calculations, potentially reducing aid eligibility.
Assets Still Included in Owners Gross Estate: If a grandparent is setting money aside to help their grandkids, the assets are still included in their estate if they pass away. This is different than if they had made a gift to one of the other accounts mentioned.
5. Roth IRAs
Technically you can make a withdrawal from your Roth IRA to fund qualified education expenses but this is a strategy I would avoid. The major benefit to the Roth IRA is the tax free growth and the impact really becomes substantial after many years.
Taking money out of your Roth IRA to pay for your child’s education will really hurt your financial future. If taking money out of your Roth IRA seems like your only option to help your child you likely should re-evaluate your plan. It might mean your child needs to go to a different school that does not cost as much or some other similar strategy.
Summary
Determining the right account for you depends on factors like tax benefits, flexibility, impact on financial aid, and contribution limits. Generally, 529 plans are the most popular due to their tax advantages and high contribution limits, but other options like Coverdell ESAs, custodial accounts and taxable investment accounts can also be beneficial depending on your specific needs and circumstances.
If you have additional questions about saving for your children or grandchildren please reach out.
Phil Francois, CFP®
Owner & Financial Advisor
Foundation Wealth Planning
https://www.foundationwealthplanning.com/