Best Accounts to Save for Education Expenses

Parents and students who are currently completing the FAFSA and learning about financial aid may be kicking themselves for not having a better plan in place to pay for college. When it comes to college costs, a little planning can go a long way.

There are several useful ways to save money for your child’s college education, each of which has its pros and cons.

A. 529 Educational Savings Accounts

  1. A plan operated by a state or educational institution, with tax advantages and potentially other incentives to make it easier to save for college and other post-secondary training, or for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school for a designated beneficiary, such as a child or grandchild.
  2. Earnings are not subject to federal tax and generally not subject to state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, as well as room and board at an eligible education institution and tuition at elementary or secondary schools. Contributions to a 529 plan, however, are not deductible for Federal Tax Purposes or NJ tax but can be claimed in some states on their state tax returns.
  3. As of 2018, the term “qualified higher education expense” includes up to $10,000 in annual expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.  A qualified, nontaxable distribution from a 529 plan includes the cost of the purchase of any computer technology, related equipment and/or related services such as Internet access. The technology, equipment or services qualify if they are used by the beneficiary of the plan and the beneficiary’s family during any of the years the beneficiary is enrolled at an eligible educational institution.
  4. Anyone can set up a 529 account and name anyone as a beneficiary — a relative, a friend, even you. There are no income restrictions on you, as the contributor, or the beneficiary. There is also no limit to the number of plans you set up. Any beneficiary initially named on any 529 account, can always be changed to yourself or any other person.

B. ESA (or Coverdell Account)- Educational Savings Accounts

  1. A Coverdell Education Savings Account is a tax-deferred trust account created by the U.S. government to assist families in funding educational expenses for beneficiaries 18 years old or younger. The age restriction may be waived for special needs beneficiaries. While more than one ESA can be set up for a single beneficiary, the total maximum contribution per year for any single beneficiary is $2,000.
  2. The ESA allows families to increase investment earnings through tax-deferral as long as the funds are used for educational purposes.

C. Custodial Brokerage/Investment Accounts

  1. UGMA and UTMA accounts are considered the granddaddy of college savings accounts. The UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfer to Minors Act) are nothing more than custodial accounts, which are used to hold and protect assets for minors until they reach the age of majority in their state. These accounts typically allow stock, bond, and mutual fund investments, but not higher-risk investments like stock options or buying on margin. Because the assets are considered the property of the minor, a certain amount of the investment income will go untaxed while an equal amount is taxed at the child’s tax rate, instead of the parents’ (or custodian’s) rate.
  2. The Potential Disadvantages:
    1. The same tax benefit that makes custodial accounts attractive can also make them unattractive. After the first amount of money in income is sheltered from higher taxes, excess income is taxed at the parents’ marginal tax bracket. This effect would not occur in a 529 plan or a Coverdell ESA.
    2. The account format also requires a custodian to hand over control of the assets to the child anywhere from age 18 to 21, depending on the state. While parents who have a good relationship with their child might be able to coerce those assets into actually being spent on college, a strained relationship may present a problem.
  3. Tax Benefits: Every child under 19 years old (or 24 for full-time students) who files as part of their parents’ tax return is allowed a certain amount of “unearned income” at a reduced tax rate.
  4. Eligible Expenses:   A custodian can initiate a withdrawal for the benefit of the child as long as the expenses are for legitimate needs. Any expense that is for the benefit of the child, such as precollege educational expenses, may be paid from the custodial account, at the custodian’s discretion. Unlike other college savings accounts, however, these expenses are not limited to education and can be used for anything related to the child. Likewise, upon becoming a legal adult, the child can use the money without limitations.
  5. Impact on Federal Financial Aid Eligibility:  Custodial accounts are considered an asset of the child and are counted against financial aid. Approximately 20 percent of these assets will be expected to be used toward funding a student’s education in any given year.
  6. Contribution Rules: There are no contribution limits. However, someone setting aside money in one of these accounts needs to be aware of how larger gifts affect their annual gift tax and lifetime estate tax exclusions. Consulting a financial adviser is helpful.
  7. Unused Funds: Any unused money must be distributed by the time the child reaches the age of majority or the maximum age allowed for custodial accounts in their state. For classic UGMA accounts, this generally occurs at the age of 18. For the newer UTMA accounts, this age is usually 21, but may be as late as age 25. Unlike Section 529 plans and Coverdell ESA’s, there’s no ability to transfer the account to another child or change beneficiaries.