Which College Savings Account is Right for Your Family?
There’s a certain kind of middle-of-the-night worrying that’s unique to parents and guardians of young kids. If you’re like a lot of the parents I work with, you’ve spent more than one sleepless night worrying about how you’re going to pay for college. Knowing that you have money growing in a college savings account should provide some peace of mind. The good news about saving for college is that you don’t have to commit to a savings plan the day your child is born. In fact, I often advise clients to take advantage of multiple kinds of accounts for maximum savings and tax benefits.
College Savings Accounts: An Overview
Any savings account that you open at your local bank can be used to save and grow money for a child’s educational needs.
But when we talk about “college savings accounts,” we’re talking about savings plans that are specifically designed for this purpose. 529 plans and Education Savings Accounts (ESAs) are two kinds of tax-advantaged college savings accounts to consider. Parents and grandparents can also take advantage of a third kind of savings vehicle, called Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) accounts.
Named for their place in the IRS tax code, 529 plans were first introduced under federal law in the 1990s and have become increasingly popular over the last decade. All states sponsor their own 529 plans, of which there are two basic types. The more popular option is a 529 savings plan. Just about anyone can open a 529 account for a child, and anyone can contribute to it. A 529 savings plan can also be used to pay for K-12 tuition, up to $10,000 per year per student. Most often they’re used for college, when the student can withdraw the money tax-free for qualified education expenses, which may include room and board, books and other non-tuition expenses.
With a 529 prepaid plan, you can use post-tax dollars to buy tuition credits at participating colleges, locking in current prices. Assuming the child attends a participating school, some or all of their tuition will already be covered. A prepaid 529 may or may not pay for other expenses like room and board. If the account beneficiary doesn’t choose one of the participating schools, you can either cash the account out to pay for tuition at a different school, or possibly transfer the funds to a younger sibling.
Education Savings Accounts (ESA)
Sometimes called a Coverdell account, an Education Savings Account shares some similarities with a 529 savings plan. Anyone in the child’s life can open and/or contribute to their ESA. The account beneficiary can withdraw the money tax-free as long as they use it for qualified K-12 or college expenses. One difference is that ESAs have annual contribution limits tied to income. No more than $2,000 can be added to an ESA in a given year, and contributors must have an annual income below a certain threshold in order to add money to the account. Multiple people can establish multiple ESAs for the same beneficiary, but their annual contributions combined can’t exceed $2,000.
If the student doesn’t go to college, the money in the ESA may be transferred to a younger family member. If money still remains in the ESA, the beneficiary must withdraw it by age 30 and pay a 10 percent penalty for not using the money on education.
While not specifically intended for educational savings, certain types of custodial accounts offer benefits that 529 plans and ESAs don’t. UGMA and UTMA accounts both work in essentially the same way, with a few minor differences (like the kinds of assets that they can hold). Parents or grandparents open the account, make contributions and control the money until the child reaches the age of majority, which is between 18 and 21 depending on the state (MA age is 21). These accounts function like irrevocable trusts. Once money is added to the account, it becomes the child’s property. The account’s custodian may only withdraw money to pay for certain expenses that benefit the child, but they don’t have to be education related. When the beneficiary reaches the age of maturity, they can use the money in whatever way they want.
Choosing a College Savings Account
So which college savings account is the best fit for your family? It really depends. Do you want to start your investment with a large lump sum and make smaller contributions down the road, or do you plan to contribute a flat amount to the account each year? Do you expect other family members will contribute to the account? Do you anticipate sending your child to public school for K-12, or will you need to pay private school tuition?
I often encourage parents to be flexible and to not feel wed to one particular kind of college savings account. I’ve often recommended to new parents that they open a UTMA account when the child is born, build up a decent balance in the UTMA and switch to a 529 later on. The first few thousand dollars in a UTMA are taxed at 0 percent or at the child’s tax rate, so this is a good starting place for your investment. Plus, you’re not locked into using the money exclusively for educational expenses.
Another reason to stay flexible is that evolving laws may also change your decisions around college savings accounts. In 2018, the Tax Cuts and Jobs Act changed several 529 provisions, including making it possible for parents to use 529 funds for elementary and secondary school tuition. If you choose one kind of college savings account and stick with it for 18 years, you risk missing out on new benefits available to other kinds of accounts.
Consulting a financial professional should be part of your process in determining what kind of college savings account is really the best fit at this time. I work closely with clients in reviewing a family’s full picture to help make the financial decisions that help them sleep better at night. If you’re looking for guidance regarding your own college savings strategy, contact me today.
Eric Sachetta, ChFC®, CFP® has been advising clients for life’s road ahead at Sachetta Callahan since he joined the team in 2016. Due to his dedication to the firm and to our clients, Eric committed to the firm by becoming a shareholder in 2019.