As schools are getting back in session, education planning is top of mind for a lot of people. Many parents and grandparents want to start saving for higher education expenses, but with a variety of savings options to choose from, it can be hard to know what the best type of account for your particular situation may be.
The most common savings vehicle we utilize with our clients are 529 college savings plans, but there are many other account types that are available depending on your profile and savings goals.
Before we dig too deep into 529 accounts, below is a quick rundown of a few of the most popular college savings options.
- Coverdell ESA accounts – Since these accounts can be opened at most brokerage firms, there are a lot of investment options available for Coverdell accounts. Contributions in these accounts grow tax deferred (and tax free if used for qualified expenses), but the biggest drawbacks to these accounts are the contribution limits ($2,000/year) and income restrictions preventing high earners from being able to make contributions.
- UTMA/UGMA – These are custodial accounts set up to hold funds for minors until they reach the age of majority. Like Coverdell accounts, they can be opened at most brokerage firms and therefore also offer a lot of investment options. There are no contribution limits (although amounts above the annual gift tax exclusion amount would be considered a taxable gift), and the account can be used for any expense the beneficiary chooses to use it for, not limited to higher education expenses. That can be helpful if the beneficiary wants to use any unused funds for a house purchase or to start a business. But it can also be a downside as they could choose to spend it all in a frivolous manner once they reach the age of majority, and not in the manner you intended when making contributions.
- US Savings Bonds – When used for qualified education expenses, the interest of Series EE and Series I savings bonds is excluded from taxes. Since they are backed by the US government, savings bonds are a relatively safe investment. But with that safety, you also accept that returns will typically be lower than what you would earn through other investments. Note that for I bonds, which have a component tied to inflation, this is an atypical year in which the initial interest rate on bonds purchased through October 2022 is 9.62%[1]. But as inflation lowers, so will the interest rate on these bonds). Savings bonds can only be purchased through TreasuryDirect online or a paper form when filing your tax return. Purchases are limited to $10,000/person/year (with a possible additional $5,000/year when purchased through your tax refund).
529 Plans
Now that we’ve reviewed a few points about these other accounts, we’ll get into why 529 accounts are more commonly used. 529 savings accounts provide tax benefits when used for qualified educational expenses and provide a great deal of flexibility.
Tax benefits
There is no federal income tax deduction when making contributions to a 529 savings account, but some states offer state tax deductions up to a certain amount each year. And earnings in 529 savings plans grow tax deferred/ tax free when used for eligible expenses.
Flexibility
529 savings plans offer limited investment options based on the plan you are using, but you’re not tied to using any specific plan based on where you reside. You can open an account using any 529 savings plan provider—they are typically sponsored by states. By doing your research (or asking your financial advisor), you can find a plan that has optimal investment options for your goals.
529 savings plans also do not have annual contributions limits. Instead, each state has an aggregate limit of lifetime contributions to that state’s plan per beneficiary. These limits are typically high, though. For instance, if you open a 529 savings plan using California’s plan, there is a lifetime contribution limit of (fittingly) $529,000. If you did want to contribute more than that, you could also open a 529 savings plan in another state. The aggregate limit is just by plan, so it does not factor in any other plans you may have.
Penalty for non-qualified expenses
A big concern for savers when looking at 529 college savings plans is what happens if you overfund a 529 savings plan and have to withdraw some of the funds for non-qualified expenses? If you make a non-qualified withdrawal, you owe tax and a 10% penalty for that withdrawal. Both of those apply only to the earnings on your contributions, however (not the principle).
Your advisor can help you determine a plan to minimize this risk, but changes in life can still be unpredictable. That being said, the penalty and tax are just on the growth, and you’ve still received the benefit of tax deferred growth for many years.
The list of eligible expenses is also fairly expansive. Examples include college tuition, private K-12 tuition (up to $10,000/year), room and board, books, computers (for college only) and more. If the beneficiary receives a scholarship, you can also withdraw up to the amount of the scholarship without the penalty and just pay tax on the earnings.
If the beneficiary still does not have enough qualified expense, the account owner also has the option to change the beneficiary to another family member that could use the account. This could be the original beneficiary’s sibling, cousin, spouse, future child or grandchild, and more.
Who can open or contribute to a 529 savings plan
Anyone! The account does not need to be opened/owned by a parent. It can be set up by a grandparent, aunt or uncle, family friend, or any interested person. But you should review financial aid considerations of the account owner with your advisor.
Similarly, anyone can contribute to an account no matter who the owner is. When my first nephew was born, I encouraged my sister and brother-in-law to set up a 529 savings plan for him. Even if they were not planning to put aside any funds yet, having the account open allowed me and other family members to opt to add money to that account as part of birthday or holiday gifts.
And each beneficiary is not limited to just one 529 savings plan. They may have accounts owned/set up by multiple people. For instance, one beneficiary may have accounts owned by two different sets of grandparents. But it is nice to coordinate these details when possible so each party can plan accordingly for how much they want to contribute over time.
Do I have to choose just one type of college savings account?
No, you can contribute to a variety of accounts as it makes sense for each unique situation. It may make sense to plan to fund a certain amount using 529 savings plans while also contributing to a UTMA custodial account (or other variations of accounts). A financial advisor can help with that decision. If you’d like to learn more about the different choices for college savings plans, Contact Team Hewins to schedule an introductory call.
1 Individual – Series I Savings Bonds Rates and Terms: Calculating Interest Rates. www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_iratesandterms.htm. Accessed 7 Sept. 2022.
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