As families prepare for the financial demands of higher education, establishing a college savings plan is essential. With tuition costs continuing to rise, considering available college savings vehicles is a valuable step in the process. Understanding the various options, such as 529 plans, Coverdell education savings accounts (ESAs), and custodial accounts, can enhance a family's ability to save for college expenses.
One of the most widely recognized options for college savings is the 529 plan. These state-sponsored accounts offer tax advantages, allowing families to save for educational expenses in a tax-efficient manner. Contributions to a 529 plan grow tax-free, and withdrawals for qualified educational expenses, such as college tuition, books, and room and board, are also tax-free.
There are no age or income limits for opening a 529 plan, making it accessible to families of all sorts. All US states offer a 529 plan, as do many brokerage firms. Families may invest in multiple states’ 529 plans, although some states provide current residents with additional tax benefits. For instance, this may include tax credits or deductions for contributions made to 529 plans.
When setting up a 529 plan, families will need to evaluate the specific features of different plans, as they can vary in terms of fees, investment options, lifetime contribution limits, and initial deposit minimums. These plans also cap tax-free withdrawals for private elementary and secondary school expenses at $10,000 per year. Funds spent on unqualified expenses are subject to income tax and a 10 percent penalty, and some place restrictions on fund transfers between children.
Another common college savings vehicle is the Coverdell education savings account (ESA), which also offers tax advantages for educational expenses. Like 529 plans, contributions to an ESA grow tax-free and withdrawals for qualified expenses are tax-free. A tax exemption applies to all funds used for elementary, secondary, post-secondary, and vocational education, regardless of the amount withdrawn. Families also have more freedom in investment selection than with 529 plans, and ESAs allow funds in one account to roll over to that of another family member.
However, ESAs have specific eligibility requirements and contribution limits. For instance, individuals with adjusted gross incomes above $110,000 and couples with adjusted gross incomes over $220,000 are ineligible to contribute. Contributions are capped at $2,000 per year, and the ability to contribute to the account ends when the beneficiary turns 18. Furthermore, ESA accounts must be liquidated by the time the beneficiary turns 30. As such, they typically work best for families who want a long-term savings option, but don’t need a large college fund.
Custodial accounts, established under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA), represent another method for saving for college. These accounts allow parents to save for their child’s education while maintaining control over the funds until the child reaches adulthood. They also offer more flexibility toward the use of funds, permitting withdrawals for any expenses benefitting the child. However, custodial accounts do not offer the same tax advantages as 529 plans or ESAs. The assets in these accounts are considered to be the child’s when applying for financial aid, which can impact eligibility for need-based assistance.
Setting up college savings vehicles requires careful planning and consideration of various personal factors, including financial status, the number of children, the children’s current college plans, and financial aid eligibility. Selecting the appropriate savings plan can position families to effectively prepare for the financial demands of higher education, as well as potentially reduce reliance on student loans. Consulting with financial professionals can provide valuable insights into how to balance savings with financial aid considerations, helping families to make informed decisions.
