College costs are going up.
Looking ahead at the bills you may face when your children reach college age can be pretty intimidating. The average annual cost of tuition, fees, room and board at a four-year public university touched $21,370 in 2018, while private schools reached $48,510, according to the College Board.
The best thing you can do to get ahead of these mounting costs is to start saving early—and to do so, you need to know your savings options. That involves understanding the differences between 529 plans, Education Savings Accounts (ESAs) and custodial accounts. Let’s take a look.
The most popular tax-advantaged education savings option is the 529 plan, named for a section of the federal tax code but sponsored by individual states. Investment options vary by state but typically include index funds or portfolios based on your child’s age. Earnings accumulate tax-free, and withdrawals are also tax-free when used for qualified expenses.
You can put large amounts into a 529, if you have the means. You can fund a 529 plan in any state, though you might risk missing out on state tax breaks if you don’t stick to your own. Where a 529 is held doesn’t affect where your child can go to college—funds can even be used for eligible international schools.
Generally speaking, a 529 account held by a parent will have minimal effect on eligibility for federal need-based financial aid. When a 529 is held by a grandparent or nonrelative, on the other hand, distributions may count as student income and could have a significant impact on financial aid decisions.
Investment options in 529 plans are limited to what the management firm, selected by the state, decides to offer, and generally you can only change how your funds are invested twice a year. Some state plans are fee-heavy, so compare costs when you’re shopping around while keeping in mind any tax advantages you may get by investing in your own state’s program.
If you withdraw money from a 529 for something other than your child’s education, you may have to pay federal income tax plus a penalty on the earnings. There are some exceptions to the penalty, however, including if your child gets a scholarship. You can hold onto a 529 indefinitely, which can be helpful if your child doesn’t go straight to college but might eventually. And you can transfer the account to any direct relative: a cousin, niece, nephew, aunt, uncle—even yourself.
The big advantage of an ESA, also known as a Coverdell, is flexibility in how it can be invested. You manage the account and choose the investments yourself, much like you would with an IRA.
ESAs’ tax treatments are similar to 529s’, in that you contribute after-tax dollars but earnings accumulate tax-free and qualified withdrawals are also tax-free. However, there is an income cap that prevents high earners from contributing to an ESA. Eligibility is gradually phased out when modified adjusted gross income for joint filers falls between $190,000 and $220,000 ($95,000–$110,000 for single filers).
ESAs can be used to pay tuition for kindergarten through graduate school, though funds must be used or distributed by age 30. As with a 529, the earnings portion of any non-qualified withdrawals may be subject to income tax and a penalty. The impact ESA funds have on financial aid eligibility is similar to that of 529 accounts.
A custodial account, also known as a UGMA or UTMA account (named for the Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act), may be useful when paying for college costs not covered by a 529 plan or ESA. However, custodial accounts are much like traditional brokerage accounts and therefore do not benefit from the tax advantages offered by 529s and ESAs.
Gifts to a child’s custodial account are irrevocable, though the parent controls how the money is spent and invested until the child reaches the age of majority (typically 18, 21 or 25, depending on the state). After that, whether the money is actually used for college is entirely up to the child.If your child has a custodial account, the impact on financial aid eligibility may be substantial. The funds are considered a student asset, not a parent asset, meaning up to 20% of the money will be considered available for education costs if applying for federal financial aid.
Gift taxes potentially apply when funds are transferred to your child’s education savings. But contributions to a 529, an ESA or a custodial account will rarely be large enough to exceed the gift tax exclusion, currently $15,000 ($30,000 for married couples) per recipient per year.
To start with, the annual contribution limit on an ESA is well below the gift tax exclusion, as are most families’ 529 contributions. If you want to invest generously in a 529 plan, however, a special rule allows you to contribute the equivalent of five years of the exclusion in a single year ($75,000 for individuals, or $150,000 for married couples) per beneficiary. You just can’t make any additional gifts in the next four tax years.
Can you have multiple accounts?
There are no rules prohibiting contributions to both a 529 plan and a Coverdell ESA, though you may find it’s simplest to keep to one tax-advantaged plan for all future educational expenses.
The most important thing is to begin saving now for your child’s education. Even if it’s just a small amount each month or year, every dollar you save is one your child won’t have to borrow, giving her or him a better chance of graduating without a heavy burden of debt.