College Savings Accounts

When it comes to saving for your child's college education, the array of account types available can seem as confusing as a student's first week on campus. Let's explore the two most common types of college savings accounts and the pros and cons of each. We'll also look at a lesser-known way to save for education and retirement expenses.

529 Plans: The Overachiever of College Savings

A 529 Plan is one of the most popular and flexible options for saving for college. Named after Section 529 of the Internal Revenue Code, these plans allow you to contribute money that grows tax-free, and withdrawals used for qualified education expenses are also tax-free. There are two main types of 529 Plans:

• Education Savings Plans - These plans work like an investment account, allowing you to invest in mutual and exchange-traded funds. The value of your account can grow or shrink depending on the performance of the investments you choose. The money in these plans can be used to pay for tuition, fees, books, supplies, and even room and board at any eligible institution.

• Prepaid Tuition Plans - These plans allow you to prepay for tuition at current rates for in-state public colleges. The primary benefit is that you lock in today's tuition rates and avoid future increases. However, these plans usually only cover tuition and fees and may limit where the funds can be used - typically only at participating in-state institutions.

Pros of 529 Plans

• Tax-free growth and withdrawals for qualified expenses.
• High contribution limits - typically between $235,000 to $529,000 per student depending on the state.
• Flexibility to change beneficiaries within the same family.
• They can be used for a wide range of educational institutions.
• Some states offer additional tax deductions or credits for contributions.

Cons of 529 Plans

• Non-qualified withdrawals are subject to taxes, a 10% federal penalty on earnings, and potential state penalties.
• Prepaid tuition plans often have limited investment choices.
• The potential reduction of need-based financial aid since assets held in 529 Plans are considered parental assets for financial aid purposes (though they have a relatively small impact).

Using Both Plans Together

There are no federal restrictions on enrolling in both types of 529 Plans simultaneously, so it's possible to contribute to an education savings plan and a prepaid tuition plan for the same student. Especially if the prepaid tuition option suits your family, the ability to lock in today's tuition while investing to cover other costs offers excellent benefits.

Using both types together also offers more flexibility. For example, even if your child decides to attend a school not covered by tuition prepayment, you would still have the education savings plan to help cover college costs. Then, the funds in the prepaid plan could be transferred to the education savings plan or another beneficiary.

That said, it's crucial to thoroughly review your prepaid tuition plan's specific terms and conditions, as the rules can vary significantly between different state plans and private institutions.

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts, or ESAs, are another college saving option. Like 529 Plans, they offer tax-free growth and withdrawals when the funds are used for qualified education expenses. However, Coverdell ESAs are more restrictive regarding contribution limits and eligibility requirements.

A significant advantage of Coverdell ESAs is that they can be used for both K-12 and higher education costs. This option makes them a good choice for families who want the flexibility to cover private school tuition, other K-12 educational costs, and college savings.

Pros of Coverdell ESAs

• Tax-free growth and withdrawals for qualified expenses.
• Can be used for a broad range of educational expenses, including K-12.
• More investment flexibility than many 529 Plans.

Cons of Coverdell ESAs

• A contribution limit of $2,000 per year per student.
• Income limits for contributors mean plan eligibility is phased out at certain income levels.
• Funds must be used by the time the beneficiary reaches age 30, or taxes and penalties may be applied to any remaining funds.

The Roth IRA Alternative

Although primarily designed for retirement, Roth IRAs can be a flexible option for college savings. When used to pay for a child's qualified education expenses:

• Contributions can be withdrawn tax-free and penalty-free at any time.
• Roth IRAs are not considered assets for financial aid purposes.
• Earnings (the gains from your contributions over time) can be withdrawn tax-free and penalty-free after the account has been open for at least five years and the account owner is at least 59 1/2 years old.

Traditional IRAs also allow for penalty-fee withdrawals of contributions for qualified educational expenses, but the amount you withdraw is subject to income tax and will be reported on your student's FAFSA for the next school year.

Remember, while IRAs can be used for educational expenses, their primary purpose is retirement savings. It's crucial to balance short-term educational needs with your long-term retirement goals. Please consider speaking with a financial advisor before reallocating retirement funds to cover the cost of your child's education.

The Takeaway

529 Plans and Coverdell ESAs are excellent options for families who want to save for college and maximize potential financial aid eligibility. They're simple to set up and 529 Plans may offer additional benefits depending on your state's rules.