In 2020, 78% of families were saving for their kid’s college education. So if you are one of the parents who is just starting out on this journey, the question is what type of account should you put your college savings into? Since there are a variety of savings vehicles, we want to break down the pros and the cons of each of the most common college savings options.
529 College Savings Plan
The most common college savings account that you hear about is a 529 plan. The federal government created these tax-advantaged savings accounts specifically for families to save for educational expenses. 529 plan savings grows tax-deferred, and when it’s time to use the funds, withdrawals are made tax-free. This means that if you save $1,000 and it appreciates in value to $4,000 in 10 years, the earnings will not be taxed when the funds are withdrawn to pay for qualified education expenses.
Although some of the rules were laid out by the feds, 529 plans are sponsored by state agencies - many of whom work with financial institutions like Vanguard, Fidelity, or Franklin Templeton to distribute and/or work as the fund advisors. Some states have multiple 529 plans to choose from. Check out this
list of the state 529 plans which includes the minimum contribution. Families are not limited to use the 529 plan in their state, but some may choose to especially if the state offers state income tax deductions to their residents.
Based on the Tax Cut and Jobs ACT of 2019, families can contribute up to $15,000 annually. Despite the fact that 529 plans were originally intended as college savings investment vehicles, qualified elementary and secondary expenses can be paid from these accounts as well as student loan repayments.
Some 529 Plans are Prepaid Tuition Plans. This means that you pre-pay future college costs today at the present day tuition and fee costs. You get the same tax-advantages for these accounts, but the qualified expenses are limited. Room and board, books and supplies, computers and internet access don’t qualify.
Even though 18 state-sponsored and one institution-sponsored prepaid plan (Private College 529 Plan) exist, only 10 are currently accepting new applicants (and 8 have state residency requirements). Typically, Prepaid Tuition Plans are typically designed to pay for tuition and fees at a specific college or list of colleges. If your kid decides to go to a different college not on the list, usually you can transfer the funds or have the funds refunded although this may mean the tax-advantage goes away.
Coverdell Education Savings Account (ESA)
Previously known as the education IRA, Coverdell Education Savings Account (ESA) is another federal tax-advantaged college savings account. Just like 529 plans, earnings are withdrawn tax-free for qualified education expenses like elementary, secondary, or postsecondary education expenses. However, ESAs can not be used for student loan repayment.
These accounts tend to be administered by a limited number of brokerage firms like
America Funds or
TD Ameritrade. Check out this list of other firms with Coverdell ESAs.
There are limits to these tax-deferred trust accounts. The maximum contribution per year for any single beneficiary is $2,000 for a specific kid. ESAs have income level restrictions. Contributions can be made only by individuals whose adjusted gross income is less than $110,000 or $220,000 for couple’s filing jointly.
Uniform Gifts to Minors Act (UGMA)
Created as a means to allow individuals to give or transfer assets to underage beneficiaries, Uniform Gifts to Minors Act (UGMA) have been helping families for almost 70 years. There is no limit to UGMA contribution. However in 2021, the federal government incentivized families to contribute to UGMA by offering up to $15,000 per individual (or $30,000 for married couple’s filing jointly) in tax-free contributions. Although many give UGMA to help pay for college, the funds may be used for other expenses of the minor/beneficiary.
Although the original UGMA gift is not taxable, account-generated earnings will be taxable when the funds are disbursed. However, the idea of the UGMA is that the beneficiary will be in a lower tax bracket than the parent or grandparent who made the contributions.
Similar to trusts, the family member sets up the fnd and appoints themselves, another person, or financial institution as the custodian of the account and decides how to invest the funds. UGMA can be invested into stocks, bonds, mutual funds, or other securities on behalf of the beneficiary. Unlike 529 plans or Coverdell ESAs, there are no maximum contributions. Also, there are no income limits.
The beneficiary of the UGMA gets full access to the funds once they are of legal age in the state that they reside. Typically this is 18 years old.
Uniform Transfer to Minors Act (UTMA)
UGMA and Uniform Transfer to Minors Act (UTMA) are almost always grouped together because they are so similar. Both are mechanisms for allow individuals to give or transfer assets to minors. However, UTMA was created in 1986 so that tangible or intangible assets like real estate, works of art, royalties or intellectual property could be given underage beneficiaries. Do be aware that Vermont and South Carolina do not allow for UTMAs.
The beneficiary of the UTMA gets full access to the funds typically at 21 years old, but there are provisions that allow for up to 25 years old.
Savings Bonds
Savings Bonds offer predictably earnings on college savings. There are two types of these low-risk Savings Bonds - Series EE and Series I. Both will pay interest until they reach their maturity in 30 years or whenever you cash the bond. These bonds can be purchased electronically at the US TreasuryDirect. The first biggest difference between these bonds is that Series EE Savings Bond has a fixed interest rate of return whereas Series I Savings Bond has a fixed interest rate plus an adjustable interest rate based on inflation. The second big difference is that Series EE Savings Bond will guarantee double its face value by the 20-year maturity whereas Series I Savings Bond has no guaranteed value at specific maturity date.
Both Series EE and Series I Savings Bonds allow individuals to buy up to $10,000 in these funds per year. However, Series I Savings Bonds lets you use your tax refund to buy up to another $5,000 bonds. For Series EE and Series I Savings Bonds issued after 1989, interest earnings are tax-free if used for qualified higher education expenses at an eligible postsecondary institution. Since November 2015, the Series EE Savings Bond have a 0.10% fixed rate issued in the six months after that date. Currently, Series I Savings Bond has no fixed rate of return but, as of November 1, 2020, the inflation rate of return after six months is 0.84%.
Colleen Krumwiede
Co-Founder & Chief Marketing Officer
Colleen MacDonald Krumwiede is a financial aid and paying for college expert with over a decade of financial aid experience at Stanford GSB, Caltech, and Pomona College and another decade at educational finance and technology companies servicing higher education. She guides go-to-market strategy and product development at Quatromoney to transform the way families afford college.
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