Which College Savings Plan is Right for You?
August 18, 2020
Saving for college is one of the biggest investments you will ever make on behalf of your child. So, it is important to choose the best savings plan for your situation. While there are numerous ways to save for college, we are going to cover the three main options, 529 Plans, Coverdell ESAs, and Custodial Savings Accounts. Which one you select will depend on your financial situation, your risk tolerance, and how likely it is that your child will seek higher education.
529 Plans are tax-advantaged education savings plans sponsored by states, state agencies, or educational institutions. In addition to paying for college tuition, 529 Plans allow for up to $10,000 per year to pay for tuition at public, private, or religious elementary or secondary schools. They have large contribution limits, with some states having limits as high as $500,000. There are two types of 529 Plans: Prepaid Tuition Plans and College Savings Plans. Every state and the District of Columbia has at least one 529 Plan available.
Prepaid Tuition Plans
There are 11 states that offer Prepaid Tuition Plans, with nine that are currently accepting new enrollment (Pennsylvania is one of them). Prepaid tuition plans allow the saver to purchase tuition credits at today’s prices to pay for education expenses in the future. This means that if the cost of tuition increases by the time your child goes to college, your savings will still cover the same number of semesters.
Most of these plans are sponsored by state governments and are only offered to residents of that state. Some states guarantee the money in the plan and others do not. If not guaranteed, you could lose some or all your money if the state has financial difficulty. Contributions to prepaid tuition plans must stay in the plan for at least a year before they can be withdrawn, and these plans are best if your child plans to attend an in-state school. Funds used for out-of-state schools may incur additional fees or costs that are not covered by the plan. Many of these plans only cover tuition and fees and may not pay for all your child’s college expenses. The PA Guaranteed Savings Plan is one of the few prepaid tuition plans that does allow you to pay for room and board. The main advantage of these plans is your college savings are guaranteed to keep pace with rising tuition costs.
College Savings Plans
College Savings Plans are the most common type of 529 Plan. These are investment-related savings plans that allow the saver to invest in mutual fund or exchange-traded fund portfolios. Plans usually offer a variety of investments including risk-based and age-based strategies, as well as the ability to create your own mix of funds in the plan. Risk-based portfolios maintain a static allocation of stocks and bonds in risk categories from conservative to aggressive, and age-based portfolios automatically change the allocation to become more conservative as the child gets closer to college age. The investment growth is tax-free as long as the funds in these plans are used for qualified education expenses. Unlike prepaid tuition plans, investment growth is not guaranteed, and the saver is responsible for managing the investment risk. If you have a shorter time period before your child attends college, a prepaid tuition plan may be the better option since your savings is guaranteed to grow with rising tuition costs.
Unlike prepaid tuition plans, most college savings plans do not have a residency requirement, which means that a Pennsylvania resident can invest in another state’s plan. College savings plans can be used for qualified education expenses, including tuition, mandatory fees, and room and board, while most prepaid tuition plans only cover tuition and mandatory fees.
All 529 plans have fees and expenses and it is important to understand them before you choose which plan to use. Prepaid tuition plans may charge enrollment fees and ongoing administrative fees. College savings plans may have similar fees plus account maintenance fees, program fees, and asset management fees. Plan sponsors may waive some fees if you set up a systematic contribution to the plan or maintain a certain account balance. One way to lower fees is to invest in a state-sponsored, direct-sold plan because broker-sold 529 plans often have higher fees and expenses. Pennsylvania’s direct-sold plan is known as the PA 529 Investment Plan.
529 plans provide several tax benefits for the saver, depending on the state. Some states, like Pennsylvania, allow savers to deduct 529 plan contributions from state income tax. All 529 plans offer tax-free growth on withdrawals used to pay for qualified higher education expenses. If withdrawals are not used for qualified educational expenses, the growth or earnings will be subject to state and federal income taxes, plus a 10% penalty. If your child does not attend college or does not use all the funds in the 529 plan, the account can be changed to another, related beneficiary who can use the funds for college.
Coverdell Education Savings Accounts
Coverdell Education Savings Accounts (ESAs) are another tax-favored savings vehicle designed for both K-12 and college expenses. The primary benefit of these accounts is that your savings grows tax-free and withdrawals are tax-free if the money is used for qualified educational expenses. They also offer more investment options than 529 plans.
However, there are several restrictions placed on these accounts which limit their usefulness. First, your modified adjusted gross income (MAGI) must be below $95,000 for single tax filers and $190,000 for joint filers to be eligible to make the full contribution of $2,000 per child per year. This contribution limit makes it virtually impossible to save all your child’s college expenses in an ESA. Second, after the beneficiary turns 18, additional contributions can no longer be made without paying an additional 6% tax on them. Third, all unused funds must be distributed to the child by the time they are 30 years old. The funds cannot be returned to the one who initially invested them, and if they are not distributed to the beneficiary within 30 days after turning 30, they will be subject to a 10% penalty.
Custodial Savings Accounts
Custodial Savings Accounts are savings accounts that do not necessarily have to be used for educational expenses. With this type of account, a parent or grandparent (custodian) manages the account for a child (minor) until the child reaches the age of majority (this age differs by state, but in Pennsylvania, it is 18). Once the child has reached that age, they are able to use the funds in the account however they see fit. When used to save for college, these accounts offer the saver flexibility if the child does not pursue higher education because there are no requirements that funds in these accounts be used for education.
There are two types of Custodial Savings Accounts: UGMA and UTMA accounts. While UGMA accounts can be found in every state, not every state has adopted UTMA accounts. UGMA refers to the Uniform Gifts to Minors Act which made this type of Custodial Savings Account possible. These accounts can invest in stocks, bonds, mutual funds, cash and insurance-related investments. UTMA accounts (Uniform Transfers to Minors Act) include the same types of investments as UGMA accounts, plus real estate, jewelry, collectibles, intellectual property, and other alternative assets.
Once money is placed in a UGMA/UTMA account, it is considered a gift to the child, and the account is technically owned by the child. Investment earnings in these accounts are taxed at the child’s tax rate–usually lower–rather than the parent’s rate. Any annual earnings over $2,200 are taxed at the parent’s rate. While these accounts can be great savings accounts for children, they are not great for college savings because of the taxes and the fact that parents generally want to control their college savings past the child’s age of 18.
While there are numerous ways to save for college, the three primary savings vehicles are 529 plans, Coverdell ESAs, and Custodial Savings Accounts. 529 plans offer the most benefits and are the most widely used for saving the bulk of a child’s future education expense. If you qualify for the Coverdell ESA, these can be a nice supplement to a 529 plan, but their limits make them less appealing. Custodial Savings Accounts offer flexibility in how the money can be used and are a great way for your child to save for books and spending money. Of course, choosing the best savings plan for you will depend on a number of factors, including your income, financial status, your child’s age, likelihood that your child will attend college, and more.
Trinity Wealth Management
If you are thinking about starting a college savings fund, you will want to ensure you pick the best option for your child’s future. Our fiduciary financial advisors are here to help. Contact us today for more information on how we can help you secure your child’s future education.
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