529 plans are great, but they aren’t the only option when it comes to college savings
As I mentioned in my previous post, “Is your child ready to graduate from the piggy bank?”, there are many different types of accounts that help kids save money. Whether it’s money they are earning and saving themselves, or if you are interested in saving on their behalf, the landscape of financial products can be messy and complicated.
With the costs of college skyrocketing at an alarming rate, and 45 million Americans strapped with $1.71 trillion in student loan debt, it’s not surprising that college savings plans like 529s are getting a lot of attention these days among parents. However, they aren’t the only option nor a silver bullet for college savings.
When it comes to saving for any goal, college or otherwise, where you put your money matters.
529 Plans
The primary benefit of a 529 plan is the tax-free growth. As long as the money in the account is used for qualified education expenses it is exempt from federal taxes. One of the biggest misconceptions around 529 accounts is the notion that “qualified expenses” only include college. As of 2019, funds in a 529 plan can be used for private schools, religious schools, apprenticeships, and home-schooling (hello, pandemic anyone?). And, I learned something new today…up to $10,000 from a 529 account can even be used to pay down student loan debt.
Unfortunately, if you find yourself unable to use your 529 funds for anything education-related (e.g., your kids are lucky enough to get full scholarships), you will be hit with a painful 10% penalty fee if you use the earnings for anything else. Another small drawback to the 529 account is that a portion of the funds built up in the account (only up to 5.64%) is considered a “parent asset,” which can reduce some of your child’s financial aid eligibility.
Coverdell Education Savings Accounts (ESAs):
Similar to a 529 plan, a Coverdell ESA offers tax-free growth if the funds are used for qualified education expenses including private school, college tuition, room and board, and more. One of the biggest differences between a Coverdell ESA and a 529 is the limit on contributions. You can contribute a maximum of $2,000 per year to a Coverdell account and only if your income is below $110,000 (single filers) or $220,000 (married filing jointly).
However, whereas a 529 limits the use of funds for K-12 education to $10,000 per year, Coverdell accounts have no limit. This can be beneficial, but given the lower maximum annual contribution limit to a Coverdell, it can be hard to save up as much as you can in a 529. Additionally, there can be greater investment options with a Coverdell account, but if you’re not a DIY type of investor, this probably won’t be as important to you.
Custodial Accounts
Custodial accounts don’t get the attention they deserve. What they lack in tax advantages, they make up for in flexibility. Sometimes referred to as an UGMA (Uniform Gift to Minors Act) or UTMA (Uniform Transfer to Minors Act), these accounts allow you to save money on behalf of your child and use the funds for anything that benefits him or her.
If you already have a 529 account established for your child but you also want an option with high-growth potential to help them save their own money for large purchases other than higher education, this type of account might be a good supplement.
Personally speaking, I was tired of seeing a growing pot of my two girls’ birthday money sitting in a savings account and earning less than 1%, so I recently opened UTMA accounts for both of them. I plan to utilize this as their default savings account until they are old enough to need access to it, at which point we can have a conversation around moving it to a kids checking or savings account.
It’s important to note that custodial accounts come with some tax implications. If you are curious about opening a custodial account, I recommend speaking with a tax professional or your financial institution to learn more.
It doesn’t have to be one or the other
Between these savings options as well as others choices like a high-yield savings account or even a brokerage account, there are many options when it comes to saving for college or any major financial purchase. There isn’t a one-size-fits all solution and, in some cases, such as if you’re not 100% sure what you’ll need that far in the future, it might make sense to spread your savings across multiple accounts.
The most important part of the whole process is to talk to your kids about the cost of college together, and to start that conversation as soon as possible. Whether you plan to pay for all of it or none of it, it’s important to set expectations as early as possible.