Since its debut in 1996, the 529 college savings plan has been well regarded as one of the best vehicles available for those saving for college. The plan has now been expanded to cover K-12 education, under the Tax Cuts and Jobs Act.
The federal tax-free withdrawal of savings, when used for higher education expenses, combined with very high contribution limits make these plans ideal choices for college savings. There are two main types of 529 plans—prepaid tuition plans and savings plans. With a prepaid tuition plan, money is paid in advance for the child's tuition and fees at certain schools. The savings plans are similar to IRAs and are considered to be tax-advantaged investment vehicles. Some plans offer the additional benefit of state tax deductions for contributions made within their plans.
For as solid as 529 plans are overall for saving for college, they are not the ideal choice in every situation. Depending on individual circumstances, other college savings options are available that may be more ideal. As college costs continue to rise, savers need to be aware of every possible advantage.
- The 529 college savings plan—which offers tax-free savings, when used for higher educations costs, and very high contribution limits—is an ideal choice for many people looking to pay for education.
- The Coverdell Education Savings Account (ESA) is a good alternative that offers more investment options and tax-free withdrawals for elementary and secondary costs, as well as college.
- UGMA/UTMA are accounts in which the balances are to be used to benefit a child, although not specifically for education; the accounts are taxed at the lower child tax rate and investment options are broad.
- Prepaid tuition plans let students buy future tuition credits at current rates, saving money in the long run; however, only certain schools participate and the investment options are more limited.
- Although not geared toward college savings, taxable accounts are also a way for parents to save money for a child's education; the accounts have no special tax benefits and are held in the parents' names.
Coverdell Education Savings Accounts
One of the drawbacks of 529 plans is some may offer a relatively limited menu of choices. Many plans have expanded to increase their available investment options including age-based and risk-based portfolios. Those unhappy with the choices within their state's plan may find the Coverdell Education Savings Account (ESA) an attractive option.
Coverdell accounts to solve the problem of limited investment options in that they allow investment in almost any security, such as stocks, bonds, and funds. They have the additional advantage of allowing tax-free withdrawal of earnings for qualified elementary, secondary and college costs, while 529 plans only provide this provision for college costs.
Low contribution limits and age-limit restrictions are disadvantages of the Coverdell. The total contribution plan limit for the Coverdell is only $2,000 annually and does not index to inflation. Balances in the plan must also be withdrawn by the time the beneficiary reaches 30 unless transferred to another family member.
Some of these 529 plan alternatives are not as well known as a 529 plan, but should at least be considered by most investors.
The Uniform Gift to Minors Account (UGMA) and Uniform Transfer to Minors Account (UTMA) do not provide the tax benefits of the 529 plan, but they do allow account holders a great deal of discretion in where the money goes and how it is used.
While balances in the account are to be used for the benefit of the child, they are not specifically earmarked for college. This may be an especially useful benefit for parents who are unsure if their child will actually go to college. Like the Coverdell, investment options for the UGMA/UTMA are virtually unlimited.
Withdrawals from UGMA/UTMA accounts are taxable, albeit at the child's tax rate, which is usually the lowest bracket. For those wishing to use balances in these accounts for college tuition, the potential for receiving financial aid could be impacted. Since UGMA/UTMA account balances are considered assets while 529 balances are exempted, they may make it more difficult to qualify for financial aid.
In terms of taxes, the rules regarding how the plans work are spelled out in Section 529 of the Internal Revenue Code; legally, the plans are called "Qualified Tuition Programs," but are often referred to as "Section 529 plans."
Prepaid Tuition Plans
Prepaid tuition plans are a relatively newer option for college savings. These plans allow students to purchase future tuition credits at current rates, leading to significant potential cost savings down the road. Investment in these plans is generally more similar to 529 plans in that the plans offer a menu of options typically including mutual funds.
The primary drawback of the prepaid tuition plan balances can only be used at participating colleges and universities. Balances in these plans are normally only eligible to be used for tuition. Room and board costs are only eligible in rare cases.
Taxable accounts are held in the names of the parents and provide no specific tax benefits but keep ownership of any balances in the parents' names. While the account may be used for college expenses or any other purpose for the child, it is not necessarily committed, leaving the parents free to use any balances in the account for any purpose without the withdrawal penalties that may accompany the options listed above.