Three types of college savings accounts are the 529 Plans (Prepaid Tuition Plans & Education Savings Plans), Educational Savings Accounts (ESAs/Coverdell accounts), and Custodial accounts (UGMA/UTMA). 529 plans and Education Savings Accounts (sometimes referred to as ESAs or Coverdell accounts) are saving plans that American parents can use to help finance their children’s college education. With the exception of custodial accounts, the other two accounts come with tax benefits which can be redeemed if they’re being used to finance qualified academic expenses like accommodation, tuition, laptops, or books.
All types of college savings plans have one common objective, which is to help parents fund their child’s education. However, all college savings accounts come with varying key features like the flexibility of funds, their impact on your child’s financial aid eligibility or contributions you’re allowed to make. We’ve put together a detailed overview of 3 college savings accounts to help you understand your options and determine the best pick for your child’s education that also aligns with your savings strategy. Review savings account options for your college savings plan:
Common Types of College Savings Accounts: 529 Plans
Created under section 529 of the Internal Revenue Code, 529 plans – also known as qualified tuition plans – are savings accounts which are state-sponsored by different agencies or educational institutions to encourage significant investment towards a child’s future education. 529 plans vary by state and each state in the United States offers at least one plan to its residents. However, it’s not mandatory to participate in your home state’s 529 plan if the terms (i.e costs, key features, and investment mix) of another state appeal to you more.
Equally important, withdrawals from a 529 plan can only be used on approved educational expenses in eligible post-secondary institutions. If the money is used for anything else, you’ll be subjected to an income tax and a penalty fee. Although a 529 college saving plan covers basic college expenses, inevitable costs such as tutoring, test preparations, transportation, and pre-college expenses are not covered in the plan.
To summarize, 529 plans come with the following key features:
- Opening a 529 account has no restrictions. Anyone can do it.
- Friends and family are free to contribute to a 529 plan regardless of who was in charge of opening it.
- 529 accounts don’t have income limits for parents who want to open and fund one under their plan.
- Compared to other types of college savings accounts, 529 plans have higher contribution limits and offer the account holder more control and flexibility.
- Depending on the state, lifetime contributions can go above $300,000 per beneficiary.
- Withdrawals from a 529 plan can only be used on approved educational expenses in eligible post-secondary institutions.
- It’s possible to jump-start your child’s college fund contributions by depositing up to $75,000 annually (or $150,000 as a couple) without attracting a gift tax.
Below is an overview of the two major types of accounts under the 529 college savings plan.
Prepaid Tuition Plan
Under this plan, account holders can buy units/credit at participating tertiary institutions (mostly public and in-state) to cater for their child’s future tuition fees at current prices. Future college and university accommodation and elementary/secondary tuition are, however, exempted from this plan.
Most prepaid tuition plans in the United States are state-sponsored and come with a level of measured guarantee – not all state governments guarantee your money. If your tuition payments aren’t guaranteed, it’s possible to lose some or all your contributions if the plan’s sponsor faces financial challenges. Review interest rates for different savings accounts in your area:
Education Savings Plan
An education savings plan allows the account holder to open an investment account for the purpose of funding a beneficiary’s approved higher education expenses in the future. Withdrawals from these types of college savings accounts don’t have limitations and can be used at any tertiary institution, including some non-U.S. universities and colleges.
Unlike prepaid tuition plans, funds from education savings plans can also pay for tuition at public and private elementary/secondary schools up to $10,000 annually per beneficiary.
You can use My State’s 529 Plan to view a summary of every State’s 529 plan. They also have a practical tool that allows you to compare 529 plans by state and features to help you weigh all your options.
Educational Savings Accounts (ESAS/Coverdell Accounts)
Educational Savings Accounts(ESAs) – sometimes called Coverdell accounts – share a number of similarities with 529 plans. For instance, they both have tax benefits and allow you to save up for your child’s educational expenses. The defining difference between the two is that ESAs are not limited to college expenses and can be used for elementary/secondary educational expenses as well.
On the flip side, ESAs have some restrictions that are not applicable to 529 savings accounts. For example, the beneficiary of an ESA account can no longer contribute to their account after they reach 18 years, and all their ESA funds must be used up before they reach 30 years.
Disclaimer: The account’s beneficiary can roll over any unused balance after the age of 30 to another family member’s Coverdell account to avoid taxes or penalties.
Other important facts about ESAs to consider before opening one include:
- Eligibility criteria. Only individuals with an adjusted gross income of less than $110,000 can open ESAs (that figure is $220,000 for couples)
- ESAs have more decision-making power regarding the mix of investments you can make (529 plans are a bit limited in scope). An ESA holder can choose which investment best suits them, and a prudent investment strategy will substantially increase your account’s value.
- Contributions have an annual limit of $2,000 (regardless of how many people are contributing to the account) until the beneficiary turns 18 years old. If you anticipate larger contributions, 529 plans might be a better fit for you instead.
Custodial Accounts (UGMA & UTMA)
Minors generally don’t have rights to get into bonding contracts, and cannot, therefore, own bonds, annuities, or stocks. In short, parents cannot transfer assets directly to their children but can use a trust instead. Two of the most common types of college savings accounts that fall under this category are UGMA and UTMA accounts.
The Uniform Gift to Minors Act (UGMA) is an established trust that allows minors in the United States to own securities without the need for an attorney or a trustee appointed by the court. State statutes dictate the terms of this trust in every state.
The Uniform Transfer to Minors Act (UTMA) is interchangeable but goes a step further and allows minors in the United States to own a wide selection of property like real estate and fine art. These types of college savings accounts give the beneficiary permission to gain ownership of the money within the accounts once they reach 18/21 years.
These accounts don’t have tax benefits and the beneficiary usually becomes the account holder upon maturity. At this point, the custodian (you) will no longer have a say over how the beneficiary uses the money.
Knowing beforehand how much money your child’s college education will cost can help you determine a suitable type of college saving plan to go with. College Savings Plans Network’s free college cost calculator will give you an estimated cost of your child’s college education after filling in a few mandatory fields.