Education Savings Options

Last week we covered a number of important steps that families must consider as they welcome a new family member. Whether it’s your first child or seventh, education savings is an important topic that should be addressed sooner rather than later. Fortunately, there are multiple educational savings vehicles available for you to choose from. We’re going to cover a few options to hopefully make that decision easier for you.

The first, and primary option we’ll cover is 529 plans. Most states offer a 529 (or similar) plan, which allows you to save for qualified educational expenses. While the money you contribute to a 529 plan isn’t tax-deductible for federal income tax purposes, more than 30 states provide tax deductions or credits of varying amounts for contributions to a 529 plan. The earnings in a 529 plan are exempt from federal income taxes, provided the money is used for qualified educational expenses. Any other withdrawals are subject to taxes plus a 10% penalty, with exceptions for certain circumstances, such as death, disability, or if the student receives a scholarship. There are no annual contribution limits on how much you can contribute to a 529 plan. However, contributions to a 529 plan count as gifts for gift-tax purposes. Contributions beyond the annual gift tax exclusion may be subject to gift taxes (currently $15,000 per year). 

Thanks to the Secure Act of 2019, qualified education expenses are no longer exclusive to college — you could employ the funds for private elementary, secondary or religious schools, as well as apprenticeships, home schooling and even student loan debt repayment (up to $10,000). With few exceptions, the named beneficiary has no legal rights to the funds in a 529 account, so you can assure the money will be used for its intended purpose. The account owner has full control over the account, and they keep the right to change the beneficiary, as it is portable. This can be beneficial in an instance where one child doesn’t use all of the funds, or maybe they receive a scholarship. You have the ability to change the beneficiary to a different child who still has an opportunity to use the funds. 

The next plan is a Coverdell Education Savings Account (ESA). These are similar to a 529 in that the contributions are not tax-deductible but the earnings do grow tax-deferred and are exempt from federal and state income taxes, provided the money is used for qualified educational expenses. Since broadening the definition of qualified expenses for 529s, ESAs aren’t as attractive of a savings vehicle. There are also contribution and income limits which will hinder certain participants from using ESAs. 

UGMA and UTMAs are also another option when it comes to college savings. UTMA stands for Uniform Transfers to Minors Act, and UGMA stands for Universal Gifts to Minors Act. Typically, these accounts function as a type of custodial account designed to hold and protect assets for the beneficiary. Friends and family can make contributions to the accounts, which carry no contribution limits or income limits. These deposits are irrevocable—they become permanent transfers to the minor and the minor’s account. Typically, these assets are used to fund a child’s education, but the donor can make withdrawals for just about any expenses that benefit the minor. There are no withdrawal penalties. However, because UGMA assets are technically owned by the minor, they do count as assets if they apply for federal financial aid for college, possibly decreasing their eligibility. Once the child has reached the age of majority in their state, they are granted full access to their account. At that point, they may use the funds as they please.

In addition to 529s, ESAs, and UGMA/UTMAs, a Roth IRA is one common account type that is often overlooked as a college savings option. Like the 529, there is no income tax deduction when you contribute to a Roth IRA. Instead, your contributions and earnings grow tax-free. An additional benefit is because you’ve already paid your taxes, you can withdraw contributions at any time, for any reason, tax-free. In addition, once you reach 59½ (and it’s been at least five years since you first contributed to a Roth), all of your withdrawals—earnings as well as contributions—are tax-free. That means 100% of your withdrawals can go to college expenses. The Roth IRA can also allow for more freedom in investment options in comparison to a 529, as most 529 plans are limited in their investment selections. Check out our past blog for more details on Roth IRAs.

Overall, there are many college savings options available. The objective is figuring out which is going to fit your situation the best. While a 529 might make sense in most cases, it’s important to work with a planner to better understand your unique situation and make an educated decision.

Ben Webster, CFP® and Derek Prusa, CFA, CFP®

Co-Founders and Owners of Aspire Wealth