Get Smart About Saving For College

College costs are going up--which plan is best for your child?

Looking ahead at college bills—currently about $24,600 per year at an in-state public university and about $49,300 at a private school, according to the College Board’s 2016-17 data—you might feel as if you’re drowning not just in numbers, but letters, too: What’s the difference between a 529, an ESA, a Coverdell, and an UTMA or UGMA?

In a nutshell, 529 plans and Education Savings Accounts (ESAs), also known as Coverdells, offer tax-deferred growth and tax-free withdrawals for qualified expenses. Custodial accounts, also known as UGMAs or UTMAs (named after the Uniform Gifts to Minors Act and Uniform Transfers to Minors Act), feature fewer restrictions and limited tax benefits.

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Making sense of 529 plans: You can save the most in this plan while still getting tax breaks.

529 college savings plans are sponsored by individual states, and let you invest in a selection of age-based or static investment portfolios. The plans are managed by state-appointed investment managers.

Withdrawals are tax-free for qualified college and graduate school expenses. There are no annual contribution limits—just a lifetime limit of about $300,000 or more per beneficiary for all states. Also, bear in mind that you can fund a 529 plan in any state without limiting your child’s choice of college and gift taxes may apply.

Additionally, 529 savings have a minimal impact on federal financial aid because they are assessed at a much lower rate than the child’s assets. If a grandparent or other relative has a 529 account with your child as the beneficiary, those distribution payments will be counted as student income and could have a significant impact on financial aid decisions.

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Bear in mind that 529 plans also have some drawbacks.

Investment options are limited to what the state-appointed manager decides to offer, and you may not be able to re-allocate existing balances more than twice a year. Also, some state plans are fee-heavy, so compare costs when you’re shopping around. There might be tax advantages to investing in your own state’s 529 plan, but not all states offer tax breaks.

Cashing out will count as a non-qualified withdrawal, and the earnings portion (meaning growth from dividends and price appreciation) will be subject to federal and state income tax, plus a 10% penalty. If your child gets a scholarship, you can request a penalty-free withdrawal—but even if that's granted, you may still be taxed on earnings.

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Understanding education savings accounts: You control your ESA investments and can use the funds for a range of education-related investments.

A Coverdell Education Savings Account, formerly called an education IRA, is like a retirement IRA in three ways: You directly manage the account, choosing the investments yourself; there is an income cap (your modified adjusted gross income must be $220,000 or below, if you file jointly); and there’s a maximum annual contribution ($2,000 per beneficiary).

Advantages: ESAs can be used to help pay tuition from grade school through grad school. When your child turns 18, you can continue managing the account, but funds must be used by the time the child is 30. As with 529 plans, your savings will have minimal impact on federal financial aid.

Drawbacks: Other than the low contribution limit, the main restriction is that you may owe taxes and a 10% penalty on nonqualified withdrawals.

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Custodial accounts explained: You have flexibility in how you can invest and spend the money.

A custodial account is a brokerage account that you set up and manage on behalf of a child. It’s turned over to them when they reach the age of majority (21 in most states).

Advantages: The sky’s the limit in terms of contributions, and there are no restrictions on your investment options. Gift taxes may apply.

Drawbacks: This gift is irrevocable, and once your child reaches the age of majority, he or she can spend the money on college—or anything else; you no longer control the funds. Also, income from the accounts may be subject to “kiddie tax” rules where investment income above $2,100 is subject to be taxed at the parents’ rate.

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How gift taxes apply to college savings.

Contributions to these three types of accounts count as gifts, for which you can claim the yearly $14,000 ($28,000 for couples) exclusion per child. If you want to invest more generously in a 529 plan, you can contribute what amounts to five years of the exclusion in a single year ($70,000 for single parents; $140,000 for couples) per beneficiary. You just can’t make any additional gifts in those five years.

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It’s possible to fund more than one type of college account. But you may find it’s simplest to keep one tax-advantaged plan for educational costs, and a custodial account (or even a regular brokerage account) for other expenses that wouldn’t qualify for tax-free distributions—like a car—anyway. IRS publication 970 can help outline the tax implications of your choice.

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Why Not Depend on Financial Aid or Loans?

Most parents can count on their child to receive financial aid—indeed, 82% of full-time college students at four-year institutions receive some sort of assistance, according to a 2013 survey by the National Association of College and University Business Officers. But particularly for affluent families, a substantial portion of financial aid may be loans, according to data from edvisors.com.

The more you save up front for college, the less your child may have to borrow in the future.

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Learn more about creating a customized financial plan and investment portfolio with Schwab Intelligent Advisory^TM to work toward a better future for your family.

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