A Comparison of College Savings Options

After a child is born, they progress through an infinite number of “firsts.” First breath. First cry. First laugh. First tooth. First steps. What about first investment?

Many parents wish to invest for their child’s future college costs and understand how much of a burden that could be years down the road. They’ve made the decision to save, but what they really want to know is how. There are many different options for saving/investing for a child’s post-secondary education and these options can be confusing. To complicate matters even more, advice on what the best option is often comes from a company representative that may not have the parent’s nor the child’s best interest at heart.

The goal of this post is to give parents information on the most popular college savings options available to help them in their decision on what is best for their individual situation. Options can vary from placing money under a mattress each month, to intricate trusts, but the focus of this post will be on the most popular options used today. I’ll begin with a brief introduction for each, followed by a table comparing the various options.

College Savings Options

529 College Savings Plans

A 529 plan is a state or institution-sponsored education savings plan. It is named after section 529 of the Internal Revenue Code, which outlined the creation of these types of plans. Although these plans are state-sponsored, a person can use any state’s 529 plan. Certain states provide state-level tax incentives for using the plan of the resident’s state. Here is a map and calculator to see if your state provides such incentives, and if so, how much it is worth. For example, my home state of Kentucky does not provide any sort of tax incentives for using the in-state 529 plan, therefore residents are free to use whichever state’s plan they would like. Not all state 529 plans are created equally, some being better than others. You can use this tool to research some of the best plans in the nation, but keep in mind, past performance is no guarantee of what it will be in the future. It’s also important to note that there is a such thing as a 529 Prepaid Tuition Plan, which will not be discussed in this post. 529 plans are by far the most popular, and growing, education savings plans.

Coverdell Education Savings Accounts (ESA)

This account was previously known as the Education IRA prior to 2002. These accounts are similar to 529 plans in many ways, with several exceptions. Some of which are that the ESAs have an annual contribution limit (see table blow), they can be used for K-12 qualified education expenses, and they have income phase-out restrictions. These types of accounts are often used by those sending their children to private elementary or high school institutions because of the unique K-12 rules of this type of account.

UGMA/UTMA Account

The Uniform Gift to Minors Act (UGMA), and a slight variation of it, the The Uniform Transfer to Minors Act (UTMA), were established to give people a means to transfer investment assets to minors without the need of an attorney to establish a formal trust. In this account, a custodian holds possession of the assets until the child reaches the age of majority for that particular state; the account is managed by the trustee (typically the parent of the child) until that point. The important differences between this account and the other above is that all assets placed into the UTMA constitute a legal gift to the minor and therefore are included in the assets of the minor, which may not sound like a big deal, but for financial aid considerations in the college application process, it can make a big difference.

Savings Bonds

There are 2 types of savings bonds available today. The difference between them is in the way in which they accumulate interest. Series EE Bonds are purchased at face value and have a guarantee from the government to at least double over the initial term of the bond (typically 20 years). Series I Bonds do not come with any guarantees to double over the term of the bond, but they do come with a fixed interest rate and an additional inflation adjusted rate of return. These bonds have certain limitations and income restrictions, but the interest earned is tax-free if used for qualifying education expenses. These bonds are often used by those that have a high desire for a conservative rate of return, backed by the full faith of the U.S. government.

529 Plan ESA (Coverdell) UTMA/UGMA Savings Bond
Who Owns It? Parent/Contributor Parent/Contributor Custodian until child reaches age of majority Parent/Contributor
Other than tuition, what can it be used for? Books, computers and equipment, supplies, etc. Books, computers and equipment, supplies, etc., certain Kindergarten - 12th grade expenses No restrictions Books, computers and equipment, supplies, etc.; Contributions to 529s and ESAs
What happens if I spend it on something that's not covered? Withdrawn earnings subject to Federal tax and 10% penalty Withdrawn earnings subject to Federal tax and 10% penalty Funds must be used for the benefit of the minor Interest is taxed as income
Contribution Limit Varies by plan. Generally $250,000+ $2,000 per beneficiary per year from all sources No limit No limit
Age Limit None Contributions made before beneficiary reaches 18; use of the account until age 30 When minor reaches age of majority they have legal control over the account Owner must be at least 24 before bond's issue
Federal Tax Advantages Non-deductible contributions, but earnings withdrawn for Qualified Education expenses are tax-free Non-deductible contributions, but earnings withdrawn for Qualified Education expenses are tax-free; K-12 expenses also included Earnings and gains taxed to beneficiary (see special tax rates for minors) Interest grows tax-deferred and is tax-free if used for qualified education expenses
State Tax Advantages Varies by state None None Interest is usually exempt from state and local taxes
Income Phase-Out None No contributions if MAGI is $110,000 or more ($220,000 joint) (2016) None MAGI of less than $77,200 ($115,751 joint) for full interest exclusion (2016)
Financial Aid Impact Counted as asset of parent if owner is parent or dependent student Counted as asset of parent if owner is parent or dependent student Counted as student's asset Counted as asset of parent if owner is parent or dependent student
Investment Choices Menu of choices provided by program No restrictions No restrictions Savings bonds
Ability to Change Beneficiary Yes, to another family member Yes, to another family member No Yes

There are many options available, and some fit people better than others. It’s important to weigh the pros and cons of each option available and to decide on one that best fits your goals for yourself and your child.