Types of College Savings Accounts
The probability of landing a job skyrocket when an individual has a college degree. It’s clear why two-thirds of high school graduates enroll in college the fall following high school, according to the Bureau of Labor Statistics. However, with so many students enrolling, not nearly as much are graduating. The dropout rates at most public universities are stratospheric. But why are students dropping out? What is the top reason? Money. That’s why knowing the types of college savings accounts options is so important.
Whether students find themselves drowning in debt by their junior year or unable to keep up with climbing tuition costs, money is a huge factor in the decision to remain enrolled. As a solution to this rising problem, there are certain types of savings accounts that parents can utilize to help their student get off to the right financial start. The key is starting early and remaining consistent so by the time your student starts college, money won’t be the reason they drop out.
When considering all of the different types of college savings accounts, it can be overwhelming deciding which one to go with. They all have different features that are unique to each type and that can even offer you benefits. Keep reading to learn the different types of college savings accounts.
There are 3 main types of college savings accounts: 529 plan, education savings accounts (ESAs) and custodial accounts. All 3 can make saving towards your child’s education easier and worthwhile. Below are some questions to ask yourself to narrow in on the best option for you.
Questions to Ask Yourself
Will the funds I contribute be used towards college expenses?
This question may seem like a no-brainer, but it’s important to think about. The different types of college savings accounts impose a penalty if funds withdrawn are not used towards education.
For 529 plans and ESAs, the penalty is 10%. Coverdell funds can be withdrawn and used towards K through 12 education expenses. As of 2018, funds in 529 plans can be used to pay for tuition at elementary and secondary public, private, or religious schools.
If funds are not used towards education, penalties will apply and all earnings are taxed. Giving up money haphazardly is not what anyone wants to do. So be sure when you decide to open a college savings account, you are committed to using those funds towards higher education.
How much do you want to contribute each year?
Education savings accounts, like a Coverdell account, have limitations on the amount you can contribute each year. Coverdell accounts impose a 6% penalty on contributions in excess of its contribution threshold of $2,000 annually.
On the flip side, 529 plans generally do not have contribution limits as long as all proceeds are used towards education. However, gift tax rules could apply if contributions plus other gifts exceed $14,000.
Do you meet income requirements?
Different types of college savings accounts have different income requirements. Coverdell ESAs contributors cannot have adjusted gross income in excess of $190,000 for joint filers and $110,000 for single tax filers.
529 plans do not have income restrictions on the contributor or beneficiary.
Digging Deeper
Education Savings Account
An education savings account, a.k.a. ESA, is a tax-advantaged saving account designed to encourage saving for college and other post-secondary education expenses. Education expenses include tuition, fees, books, computer technology, room and board and any other qualified education expenses required for enrollment. Expenses do not include software designed for any other purpose other than education.
Compared to 529 plans, Coverdell plans offer a wider selection of investment options for the account holder to choose from. 529 plans have a much-limited selection of investment portfolio options.
The tax treatment of ESAs is that earnings accumulate tax-free. Meaning when funds are withdrawn for educational purposes at an eligible educational institution, the contributor nor the beneficiary will pay any income tax. But what is considered an eligible educational institution? An eligible educational institution can be an elementary, secondary or post-secondary school. This includes colleges, universities, or any other post-secondary school. Generally, any accredited school public or private would be included. If you are unsure if a school is accredited, you should check with the financial aid office.
A beneficiary does not have to be your child or dependent. However, contributions cannot be made after the beneficiary turns 18. All funds must be withdrawn by the time the beneficiary reaches age 30 unless they are a special needs student. If you are not ready to withdraw funds by the time the designated beneficiary turns 30, you can always roll over the account to another beneficiary who is under 30. This could be another child, stepchild, niece, nephew, first cousin, aunt or uncle.
At the beginning of the year, the financial institution sponsoring your ESA will send you a Form 5498 that will outline how much was contributed to your account. Here, you will see if you exceeded the contribution limit. If you have, you have a chance to correct that by requesting a refund of your contributions.
529 Plans
Other types of college savings accounts to consider are 529 plans. They have the same intended purpose as education savings accounts – to encourage parents and guardians to save towards a student’s educational expenses.
Educational expenses under 529 plans are similar to those under ESAs and include costs such as tuition, books, fees, etc. For most of its existence, 529 plans only covered costs incurred in post-secondary education. Now, 529 plans can be used towards qualified K-12 expenses and post-secondary education.
The tax advantages of 529 plans are that earnings accumulate tax-free when used for qualified education expenses. A gift tax is triggered for the contributor if they contribute more than $14,000 to any student for the year. Couples filing a joint return can contribute up to $28,000 without triggering a gift tax.
As with ESAs, a 529 plan beneficiary does not have to be your child or dependent. A unique feature to a 529 plan is that account owners can continue to contribute after the beneficiary turns 18. Some students may continue their education beyond their bachelor’s or master’s program, in which case, having this flexibility is convenient.
529 plans also allow account holders to establish an account for a beneficiary of any age. Meaning, there is no time restriction for the funds to be spent. In addition, there are not any income restrictions with 529 plans. Account holders at any income level are free to open and fund a 529 account.
There are two main types of 529 plans: prepaid tuition plans and college savings plans.
Prepaid tuition plans allow the account holder to pay the beneficiary’s tuition at a specified school in advance. This is a good way to hedge against the risk of inflation and higher tuition costs in the future. For example, an account holder can prepay 4 semesters at a predetermined institution at today’s cost and the beneficiary will be guaranteed 4 semesters, regardless of the tuition costs in the future. If for some reason, the beneficiary does not attend the institution where the prepayment was made, the difference between the payment and tuition cost of the institution attended (at today’s price) would have to be covered by the student.
College savings plans are plans where account holders can contribute up to a certain amount. Account holders have the option to choose from a variety of pre-made portfolio investments. These portfolio options are based on a student’s age and gradually become “safer” as the student gets older. Unlike prepaid tuition plans, funds in a college savings plan can be used at any accredited educational institution.
As with Coverdell ESAs, 529 plans imposed a 10% penalty tax for funds withdrawn used towards non-educational purposes. In addition to the penalty, account holders will have to pay the applicable income tax on any earnings.
FAFSA
Students and parents may still opt to apply for financial aid. FAFSA is the Free Application for Student Aid. A figure called Expected Family Contribution (EFC) is calculated, which is used to determine the student’s family financial strength in paying for college. The lower the EFC, the more financial aid that will be awarded. There are multiple factors that go into determining the EFC, two of which are parent-owned assets and student-owned assets.
Parent-owned assets are valued more favorably and if all else equals, produces a lower EFC than student-owned assets would. That is why, 529 plans and ESAs for that matter, should be owned by an account holder that is not the beneficiary. When the account is owned by the beneficiary, EFC assumes a 20% ownership in the plan. When the account is owned by a non-beneficiary EFC assumes a 5.64% ownership in the plan. Let’s take an example.
If savings in a 529 plan are $30,000, the beneficiary would claim assets owned of $1,692 ($30,000 x 5.64%), if the plan is owned by someone else. On the flip side, if the plan is owned by the beneficiary, he or she would have to claim assets owned of $6,000 ($30,000 x 20%), which would result in a higher EFC for the student. The higher the EFC, the lower the financial aid reward.
UGMA and UTMA Custodial Accounts
Uniform Gifts to Minors Act and Uniform Transfers to Minors Act (UGMA and UTMA respectively) custodial accounts are accounts designed to hold money or assets for the benefit of a minor with the intention to transfer the account’s assets to the minor when they turn 18 or 21, depending on the state. These accounts can hold stock, bond or mutual fund investments.
There aren’t any special tax advantages of using a UGMA/UTMA custodial account for education. Largely because the funds in these accounts can be used towards other non-educational expenses. Therefore, when money is withdrawn, earnings are subject to income tax.
If a student decides to use their custodial account towards education, there may be a greater impact on their eligibility for financial aid. Beneficiaries are deemed to own 20% of custodial account assets which would reduce their financial aid similar to 529 accounts.
There are not any contribution limits. Though gift tax rules do apply and amounts given in excess of $14,000 for single contributors is subject to gift tax.
What’s Next
Tuition and fees are constantly rising. There is no doubt that college is expensive. According to College Board, the average tuition and fees for a student attending an in-state, public university is $40,000 for 4 years. Double that amount for out of state or private schools. And that’s not even including the cost of room and board and books.
The different types of college savings accounts (ie education savings accounts, 529 plans, and custodial accounts) were created to make saving for a student’s future easier and beneficial.
Most people might choose an ESA or 529 plan to save toward a student’s education because of the tax benefits. Earnings and withdrawals are made tax free. Custodial accounts do not have those benefits but monies there can be used towards more than education.
When deciding how you will save for your child’s education consider the tax advantages, contribution limitations, and income restrictions. What works for you may not work for someone else. It is completely possible to set up all 3, but that does not always make sense. For example, if you qualify for a Coverdell plan but don’t make the maximum contribution, then it isn’t necessarily helpful to open a 529 plan too.
Which type of college savings account will you open for your student?