Which Education Saving Plan Makes the Most Sense for Your Family?

Nate Levinson Life with Money

If you’re a parent, or even contemplating becoming one, you know that starting a family leads to all kinds of “firsts.”
For many, it’s the first time you’ve sought out financial planning services. Life insurance, wills, trusts, saving for college – all of these can feel complex, maybe even a little overwhelming. So, in this week’s Life with Money, our focus is on education saving plans.

You can save for your child or grandchild’s education in a variety of ways, depending on your family’s needs, resources, and preferences. Three of the most commonly used funding vehicles for education saving are 529 plans, custodial accounts, and Coverdell Education Savings Accounts (ESAs).

Which education saving plan makes the most sense for your family?

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529 Plans

A 529 Plan is an investment account that has tax advantages if the funds are used for certain education-related expenses. The main advantages are that the investments are tax-deferred and withdrawals from the account are tax-free if used for qualifying education costs, which include tuition, fees, books, room and board, and many others. The primary disadvantage is a lack of flexibility in the use of the accumulated funds for non-education-related expenditures.

You as the parent can set up and own a 529 plan to help fund the education of your child, who is the account beneficiary. However, a third party, such as your child’s grandparent, can also establish and own the account.
writing a check
A 529 plan is considered the property of the person who establishes the account (either the parent or third party), not the child. The owner can transfer the funds to another 529 plan for the benefit of a different student (such as a sibling) if the funds are not needed for the original beneficiary.

Each state in the U.S. administers a 529 plan, and 529 accounts can be used to fund education in any state, regardless of where the account owner and beneficiary live. There are “direct” plans, where you open and manage an account yourself, and “advisor” plans, which involve financial institutions and are generally more expensive. Each plan offers a range of investments including bond funds, stock funds, and “age-based” funds that shift the allocation from stocks to bonds as the beneficiary nears college age. Investment selections can only be changed up to two times per year.

There are no income limits on who can contribute to a 529. And while there is no specific annual contribution limit, each state plan has a maximum lifetime contribution cap, typically in the $300,000-$500,000 range. It’s important to note here that contributions in one year above certain amounts may trigger gift tax filing requirements, even if the lifetime 529 contribution limit hasn’t been reached yet.

In terms of tax advantages, over 30 states offer a state income tax deduction for contributions to a 529 plan, although there is no such deduction against federal income tax. For these reasons, 529 plans are similar to Roth IRAs in terms of the tax treatment (i.e., no up-front federal deductions, but tax-free withdrawals). The downside of a 529 is that if you need to take a distribution for non-education-related expenses, it will be partially taxable as income and potentially subject to a 10% tax penalty as well.

Lastly, you can withdraw an unlimited amount of funds from a 529 plan each year for post-secondary education expenses. However, distributions for elementary and secondary education, as well as for student loan repayments, are limited to a maximum of $10,000 per year.

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Custodial Accounts

Custodial accounts can also be utilized for education saving. The main advantage is flexibility in use of the accumulated funds. The primary disadvantages are lack of control by parents and no tax benefits.

Similar to 529 plans, custodial accounts can be established by either a parent or third party (i.e., the custodian) with a child as the beneficiary. However, unlike a 529, you are not required to use the funds in a custodial account for education-related expenses; instead, the money can be used for any expenses related to the beneficiary.
saving for college
Also unlike a 529, custodial accounts are taxable, meaning that there is no income tax deduction for contributions and any income generated within the account (such as interest from bonds or dividends from stocks) is taxed in the year it is earned. Some of this income, above certain limits, is taxable at the parents’ higher tax rate, not the child’s rates.

There are two types of custodial accounts, known as Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts. UGMAs and UTMAs primarily differ in terms of what types of assets can be held within them. While UTMAs can hold many types of assets, such as cash, securities (including stocks and bonds), life insurance, cars, and real estate, UGMAs are generally limited to only cash and securities.

Like a 529 plan, there are no income limits on who can contribute to a custodial account, and no annual contribution limits (although gift tax considerations apply here as well). Furthermore, the investments can be changed at any time without restrictions.

The assets held in a custodial account are considered the property of the child, but are controlled by the parent or third party until the child turns 18 or reaches the “age of majority,” which varies by state. At that age, the child is legally entitled to use the money as they please.

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Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (ESAs) offer some tax benefits for education savings, but are limited by low annual contribution maximums.

ESAs are like 529 plans and custodial accounts in that they can be established by a parent or third party. Like a 529, the investments within an ESA are tax-deferred and withdrawals from the account are tax-free if used for qualifying education expenses. However, you cannot take any federal or state income tax deduction for contributions made to an ESA.
Similar to a custodial account, ESAs offer more flexibility in the account owner’s choice of investments, and there is no limit on how often the investments can be changed. Also like a custodial account, the funds in the ESA are the property of the child, but controlled by the parent or third party while the child is still a minor.

What differentiates ESAs from the other two savings vehicles is that there is an annual contribution limit of $2,000 per beneficiary per year. These contributions can only be made until the beneficiary turns 18, and can only be made by people with income below certain limits ($110,000 for a single taxpayer and $220,000 for a married couple who file a joint tax return).

Furthermore, any unused funds in the ESA must be distributed to the beneficiary by the time they turn 30, and will be taxable and subject to a 10% tax penalty if there are no qualified education expenses in that year. To avoid this consequence, the account can be depleted before the beneficiary turns 30 or transferred to a family member of the original beneficiary who is under 30 to be used for their education expenses. For these reasons, ESAs are more limited than 529s and custodial accounts in terms of how much can be contributed and by whom.

ESAs do provide more flexibility than 529s in terms of what are considered to be qualified expenses. Primarily, there is no limit on using ESA funds for elementary and secondary education, whereas this is restricted to $10,000 per year for 529 plans.

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Financial Aid Implications

One final issue to consider is the impact of education savings on the financial aid process for postsecondary education.

In the U.S., the first step in applying for financial aid is filing the Free Application for Federal Student Aid (FAFSA). On this form, the filer reports the parents’ and child’s income from two years ago, and parents’ and child’s current assets. FAFSA uses this data to calculate the Expected Family Contribution (EFC), or how much the child and their immediate family can contribute to the education costs themselves. Any remaining education costs are eligible to be covered by financial aid.

In this EFC calculation, the assets and income of the student are more heavily weighted than those of the parents. So, the more assets and income that are considered “parental” as opposed to the child’s, the more financial aid the student will receive, all else being equal.
complex formula
EFC is determined via a complex formula, but an important factor to consider is that, for parents, 47% of their income and 5.65% of their assets are counted against their child’s financial aid eligibility. For the child, 50% of their income and 20% of their assets are counted against financial aid. So, a large factor in deciding among college savings vehicles is whether the assets in the account, and income generated by the account, are considered to be the parents’ or child’s.

The assets held within a 529 or ESA are considered parental assets if the account is owned by the parent. If the 529 or ESA is owned by a third party (such as a grandparent), the funds are not counted as an asset in the financial aid calculation at all, meaning that funds in these accounts have no impact on financial aid eligibility.

Income, such as interest and dividends, generated within a 529 or ESA do not count for financial aid purposes if the account is owned by a parent, and count as the student’s income if the account is owned by a third party. Custodial accounts, on the other hand, are more straightforward. The funds in these accounts are considered the student’s assets, and income is treated as the student’s income.

Based on these factors, 529 plans and Coverdell ESAs, which have identical financial aid treatment, are preferable to custodial accounts from a financial aid perspective.

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Which Education Saving Plan Makes the Most Sense for Your Family?

529s, custodial accounts, and ESAs can all be useful education saving tools.

Out of the three, custodial accounts provide the most flexibility in how the funds can be used, but 529s offer the most tax advantages and financial aid incentives. ESAs have more investment and expense flexibility than 529s, and more tax benefits than custodial accounts, but are more limited in terms of who can contribute and how much.

Moreover, with custodial accounts and ESAs, the child has control of the money once they reach the age of majority, whereas the owner of a 529 retains control of the funds as long as they don’t transfer account ownership to someone else.

All these factors play into the decision of which education saving plan makes the most sense for your family. Contact us if you’d like further advice on this part of your planning. We’re always here to help.

Read “Which Education Saving Plan Makes the Most Sense for Your Family” in the Piedmont Exedra.