What Are the Types of College Savings Plans?

The main types of college savings accounts are 529 college savings plans, Education Savings Accounts (also known as ESAs or Coverdell accounts), and custodial accounts. Each of these college savings vehicles has their share of pros and cons, and one may work better for you depending on your goals.

If you hope to save for college for yourself or a dependent and have been wondering how to maximize each dollar you stash away, the best tax-advantaged college savings plans and their benefits are listed below.

Key Takeaways

  • 529 college savings plans are state-sponsored accounts, which grow on a tax-free basis and allow for tax-free distributions, that allow anyone to save for college on behalf of a beneficiary.
  • Education Savings Accounts (ESAs), or Coverdell accounts, offer many of the same benefits as 529 plans, but they come with income and contribution caps.
  • Unlike the other college saving plans, there are no penalties for using custodial account funds to pay for things other than higher education expenses. These accounts transfer to the dependent once they reach a certain age, which varies by state.

College Savings Plans and How They Work

While you can always save for college in a high-yield savings account or with the help of certificates of deposit (CDs), some specialized college savings plans offer tax advantages that you can’t get with other options. Consider the following types of accounts if you plan to save for higher education expenses.

529 Plans

529 college savings plans are state-sponsored accounts that let anyone save for college for a beneficiary with tax advantages included. For example, 529 plans allow anyone to make contributions that are able to compound tax free over time, and distributions are tax free if used to pay for eligible higher education expenses. Some states also offer tax advantages for contributing to a 529 savings plan up front.

In Indiana, for example, individuals get a 20% tax credit for the first $7,500 contributed to a 529 plan each year, which translates to up to $1,500 back from the state come tax time.

Note that there is some additional flexibility that comes with these plans. For starters, families can use up to $10,000 per year in funds kept in a 529 plan to pay for private school tuition at K–12 schools. The SECURE 2.0 Act also includes a provision that allows savers who have had a 529 plan for at least 15 years to roll up to $35,000 from 529 accounts into a Roth individual retirement account (Roth IRA) beginning in 2024. This transfer must be made into a Roth IRA for the beneficiary over the course of several years based on annual Roth contribution limits.

  • Funds in 529 plans can be invested for maximum growth.

  • 529 savings plan funds grow on a tax-free basis.

  • Distributions are tax free when used for eligible higher education expenses.

  • There are potential tax advantages (some vary by state).

  • Anyone can contribute.

  • There are limitations on how money can be spent or transferred.

  • Fees for these accounts vary.

  • Taxes and penalties apply when funds are withdrawn for ineligible expenses.

Education Savings Accounts (ESAs or Coverdell Accounts)

Education Savings Accounts (ESAs), also known as Coverdell accounts, are another type of tax-advantaged higher education savings option. Funds saved in this type of account can be used for eligible elementary and secondary expenses, in addition to higher education expenses.

That said, not everyone is eligible to use an ESA, as income limits apply. For example, individuals can open an ESA with an adjusted gross income (AGI) of $110,000, and an income cap of $220,000 applies to couples. Contributions can only be made until the beneficiary’s 18th birthday, and a maximum contribution of $2,000 per year applies.

Also, note that these accounts must be liquidated before the beneficiary turns 30, although the funds can be rolled over to an ESA for another family member to avoid paying taxes and penalties.

  • Funds in ESAs can be invested for maximum growth.

  • ESA funds grow on a tax-free basis.

  • Distributions are tax free when used for eligible higher education expenses.

  • Income caps limit who can use this account.

  • Contribution caps apply.

  • Fees for these accounts vary.

  • Taxes and penalties apply when funds are withdrawn for ineligible expenses.

Custodial Accounts

Custodial accounts, also known as UGMA or UTMA accounts, are opened by parents to save for their dependents. The account transfers to the child once they reach a certain age, which varies by state. This may be ages 18 to 21, depending on where you live.

With this type of account, parents can contribute funds in amounts up to the gift tax exclusion and then invest it on behalf of their dependent. This type of college savings plan also has no income limits, and anyone can contribute up to the annual gift tax exclusion amount, which is $17,000 in 2023.

  • Funds in this type of account can be invested for maximum growth.

  • Anyone can contribute.

  • Funds can be used to pay for anything, not just specific higher education expenses.

  • Contribution caps apply.

  • Fees for these accounts vary.

  • Taxes apply to withdrawals.

College Savings Plan Alternatives

Student sits at desk with other students, holding a pen

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There are some college savings plan alternatives to consider, but most of them don’t have the same tax advantages up front or potential for tax-free growth. If you want to save for college but need to find an alternative to the traditional route, consider using a high-yield savings account, saving in a Roth IRA, or investing in a brokerage account.

High-Yield Savings Account

Saving for college in a high-yield savings account is pretty straightforward. Once you open an account and begin saving, you can access the funds at any time and use your money however you want.

  • No income limits or contribution caps apply.

  • Use the funds however you please.

  • Many savings accounts come with no fees.

  • No tax advantages for saving.

  • No option to invest the funds.

  • Earning rates vary from year to year.

Roth IRA

Individuals can also save for college on an after-tax basis with a Roth IRA, then turn around and withdraw the funds to pay for a dependent’s higher education expenses (or anything else). This is possible since Roth IRA owners can withdraw their contributions at any time without penalty (just not their earnings).

That said, there are income caps that limit who can contribute to a Roth IRA, and eligible individuals can only contribute up to $6,500 across IRAs in 2023 (the maximum is $7,500 for those ages 50 and older).

  • Funds can be invested for maximum growth.

  • Withdraw contributions (not earnings) with no taxes or penalties at any time.

  • No limitations on how the funds can be used.

  • Parents who use Roth IRA funds for college may be shortchanging their retirement.

  • Annual contribution limits apply.

  • Income caps limit who can contribute.

Brokerage Account

Parents can also save for college with a traditional brokerage account, an option that offers a ton of flexibility. Brokerage accounts let individuals invest regardless of their income, and there are no contribution limits.

Funds in a brokerage account can be invested in index funds, mutual funds, exchange-traded funds (ETFs), individual stocks, and more.

  • There are no income or contribution caps.

  • You have total control over investments.

  • You can withdraw and use funds for any reason.

  • Short- or long-term capital gains taxes apply to withdrawals.

  • There are no up-front tax advantages.

What Is the Best Plan for College Savings?

The best college savings plan varies from person to person. However, 529 plans are typically considered the best option due to their tax advantages and the flexibility in how funds can be used.

Are College Savings Plans a Good Idea?

Saving for college can be a good idea if you want to avoid racking up considerable amounts of student debt.

What Is the Disadvantage of a 529 Plan?

The main disadvantages of 529 plans are the limitations on how funds can be spent and the taxes and penalties that apply if you withdraw funds for ineligible expenses.

What Happens to a 529 Plan if the Child Doesn’t Go to College?

If a child doesn’t go to college, money in a 529 plan can be moved to another beneficiary. Individuals can also roll over up to $35,000 into a Roth individual retirement account (Roth IRA) for the beneficiary, although annual contribution limits apply.

The Bottom Line

There are several ways to save for college, and you may not have to choose just one. For example, you can open a 529 savings plan, invest in a brokerage account, and set aside funds in a Roth IRA all at the same time.

If you carefully consider the pros and cons of the different types of college savings plans before you get started, you’re bound to find the right savings and investment strategy for your goals.

Article Sources
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  2. CollegeChoice 529. “State Updates.”

  3. Congress.gov, U.S. Congress. “H.R.2617—Consolidated Appropriations Act, 2023: Text,” Division T: Section 126.

  4. Internal Revenue Service. “Topic No. 310 Coverdell Education Savings Accounts.”

  5. Financial Industry Regulatory Authority. “ESAs and Custodial Accounts.”

  6. Financial Industry Regulatory Authority. “Saving for College: UGMA and UTMA Custodial Accounts.”

  7. Internal Revenue Service. “Frequently Asked Questions on Gift Taxes,” select “How many annual exclusions are available?”

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  9. Internal Revenue Service. “Retirement Topics—IRA Contribution Limits.”