Choosing the Right College Savings Account for Your Child

How to Choose the Right Kind of Account for Your College Fund

Mother and daughter in graduation gown hugging on campus
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Choosing the right college savings account for your child can seem overwhelming. There are several options, each with unique sets of complex rules. But making the right choice while your child is young—even a baby—can save you a lot of angst down the road when it comes time to apply for financial aid and search for scholarships. You can find the right type of college savings account for your child by answering a few questions.

Types of College Savings Accounts

First of all, it's important to understand the types of college savings accounts available. Each type of plan comes with its own advantages and disadvantages.

  • 529 prepaid tuition plan
  • 529 education savings
  • Coverdell ESA
  • Custodial accounts

As you consider your options, keep in mind that you might find one of these accounts better for your situation than others. It's also worth noting that you don't have to limit yourself to one type of account.

What Is Your Risk Tolerance?

If the safety of funds is your primary concern, then find out if your state offers a Section 529 prepaid tuition plan. These state plans let you buy tuition in today's dollars and get an equivalent amount of money for tuition in the future—sometimes guaranteed by the issuing state. It’s unlikely that these plans will outperform the stock market, but your money will likely be safe.

The federal government does not guarantee prepaid tuition plans, but some state governments do. However, some states do not guarantee them. To prevent losing some or all of your money, check to make sure your prepaid tuition payments are guaranteed.

If you're willing to take more risk in exchange for a possible higher rate of return, then you need to determine if your state offers a Section 529 investment tuition plan, also known as an Education Savings Plan. These plans provide you with options from reputable investment firms. If the market rises, your investment will increase accordingly, but it can also decrease if the market suffers a downturn.

With an Education Savings Plan, you normally choose from a menu of investment options offered by the custodian. If you have a lower risk tolerance, you can choose to focus on bond mutual funds and other securities considered "less risky."

Series EE and Series I bonds have historically lagged behind the Section 529 prepaid tuition plans. Using bond mutual funds in any of the other savings plans may offer an equal historical rate of return, but they are also subject to volatility and potential losses.

How Much Time Until You Need the Money?

One question to ask yourself as you consider risk tolerance is how long it will be until you need to access the money.

From 1989 to 2019, the average tuition and fees at public four-year schools more than tripled. When you consider such a dramatic rise in costs, a Prepaid Tuition plan can make sense, especially if your child is young. By locking in lower rates starting now, it's possible to build up enough credits before your child attends school.

This also applies if you're looking at an Education Savings Plan, however. With a longer time frame, you might be able to invest more aggressively at the beginning and later shift the 529's asset allocation as your child approaches college age.

Consider speaking with a financial professional who can help you develop an approach that works with your risk tolerance and time frame.

529 Plans: Prepaid Tuition vs. Education Savings
Prepaid Tuition Education Savings
Purchase future credits and current prices Invest money with the potential for growth
Limited as to where funds can be used More flexibility in where the funds can be used
Usually can't be used for room and board Room and board are qualified expenses
Guaranteed plans can protect your money No guarantees against market events
Potential tax benefits Potential tax benefits

Where Do You Live?

Many states offer substantial financial incentives for using their in-state Section 529 Savings Plan. Considering that some states essentially put cash back into your pocket for using their plan, it seems wise to take advantage. You might be eligible to receive a deduction or credit on your state income tax return, or your state might actually match your contributions to the plan, up to certain limits, if you are a resident.

Since many states offer at least one or two good long-term stock market options in their savings plans, it's probably a good move to take the "free money." Even if you don't have access to your favorite mutual fund, this initial boost can lift your returns over time.

Since most states' 529 plans primarily cover public colleges and universities, you might want to consider the Private College 529 Plan if you think your child might attend a private school.

Realize, though, that there are no federal tax benefits for contributions. While the money grows tax-free in a college savings account when used for qualified expenses, contributions are made with after-tax dollars. You might get a state tax benefit, but you won't see that same benefit at the federal level.

Can You Save $2,000 Per Child Per Year?

If you can save more than $2,000 per year, a Section 529 Savings Plan might be your best choice. The only caps placed on contributions to Section 529 savings plans are "lifetime" totals for each child. Parents can contribute to lifetime maximums that range from the low $100,000s to over $300,000. Even better, these sums grow tax-deferred and may be potentially withdrawn tax-free. Tax law changes even allow for 529 money to be used for K-12 expenses under certain circumstances. Best of all, Section 529 accounts allow the assets to remain under a parent or donor's control forever. They're even allowed to take the assets back for personal use.

If you cannot save $2,000 per year, on the other hand, then a Coverdell Education Savings Account (ESA) might be good for you. A Coverdell ESA offers freedom in selecting your investments, as well as much looser standards on how the money gets spent (including tuition for grades K-12). The case for a Coverdell gets even stronger if you have multiple children because you can transfer unused funds to another Coverdell account, or use the funds to set up a new one for other family members, including grandchildren.

Basics of the Coverdell ESA

Here are a few of the basics to keep in mind when choosing a Coverdell ESA:

  • Contributions must be in cash
  • Income restrictions for contributions
  • An annual cap of $2,000 in contributions
  • Money can't be invested in life insurance contracts
  • All of the money in the account must be distributed to the beneficiary within 30 days of them turning 30
  • Ability to transfer funds to another Coverdell for a different beneficiary
  • Flexibility in using the money for K-12 expenses

What About UGMAs, UTMAs, Roth IRAs, and Trusts?

While these vehicles offer some unique planning opportunities, they will not serve most families as well as Section 529 plans or Coverdell ESAs.

UGMA and UTMA (Uniform Gift to Minors Act and Uniform Transfer to Minors Act) custodial accounts count heavily against financial aid and require the assets to be handed over to a child usually no later than age 21 (may vary by state). Buying individual bonds in a UGMA or UTMA might get you close to the return of prepaid tuition plan, but will be subject to taxation on any interest earned above a certain amount.

A Coverdell ESA or a Section 529 account offers virtually the same tax benefits as a Roth IRA, without wasting a valuable opportunity to save for your retirement.

Trusts may sound impressive but are extremely expensive to set up and run. Don't consider one unless you want to exceed the maximum allowable Section 529 Plan contribution limit.

While there are certain situations in which these types of custodial accounts can make sense, for many people, they won't be as effective as other types of accounts—especially if you're hoping for need-based financial aid.

Choosing the Best College Savings Account for Your Child

In the end, it's up to you to do the research and consider your circumstances. Figure out what's likely to provide the most benefit while offering more options for the future. And, of course, no matter which type of account you choose, the earlier you start saving, the better off your child will be—and the less likely they'll be to need to use debt to fund their education.

Article Sources

  1. U.S. Securities and Exchange Commission. "An Introduction to 529 Plans." Accessed Dec. 12, 2019.

  2. Investor.gov. "Bonds." Accessed Dec. 12, 2019.

  3. CollegeBoard. "Trends in College Pricing Highlights." Accessed Dec. 12, 2019.

  4. IRS. "Publication 970: Tax Benefits for Education," Page 51. Accessed Dec. 12, 2019.

  5. IRS. "Publication 970 (2018), Tax Benefits for Education: Qualified Tuition Plan (QTP)." Accessed Dec. 12, 2019.

  6. IRS. "Publication 970 (2018), Tax Benefits for Education: Coverdell Education Savings Account (ESA)." Accessed Dec. 12, 2019.

  7. T.RowePrice. "General Investing Accounts for Minors." Accessed Dec. 12, 2019.