With the cost of higher education rising annually, saving for college is on every parent’s mind. There are several vehicles designed specifically for this, including 529 state savings plans, tuition plans, Coverdell education savings accounts, and custodial accounts. Each option offers different advantages and presents potential disadvantages. We are here to help you navigate it all.
529 plans: state savings plans
The 529 state savings plan is a tax-advantaged college savings vehicle governed under Section 529 of the Internal Revenue Code (IRC)—hence the name "529" plans. A state savings plan lets you save money for college in an individual investment account. Some plans let you enroll directly, while others require that you go through a financial professional. The details of these plans vary by state, but the basics are the same.
Prepaid tuition plans
Although prepaid tuition plans are similar to state savings plans in that they are governed under Section 529 of the IRC, the two plans are different. A prepaid tuition plan is a tax-advantaged college savings vehicle that lets you prepay tuition expenses now for use in the future.
Prepaid tuition plans can be run by states or colleges. For state-run plans, you prepay tuition; for college-run plans, you prepay tuition at the participating college(s). The details of prepaid tuition plans vary according to state.
Coverdell education savings accounts
A Coverdell education savings account (Coverdell ESA) is a tax-advantaged education savings vehicle that lets you save money for college, as well as for elementary and secondary education (K through 12) at public, private, or religious schools.
Before 529 plans and Coverdell ESAs, there were custodial accounts. A custodial account allows your child to hold assets that he or she ordinarily wouldn’t be allowed to hold in his or her own name. The assets can then be used to pay for college or for anything else the benefits your child (e.g., summer camp, braces, hockey lessons, or a computer).
Impact on financial aid
Your decisions on how to save for college expenses impact the financial aid process. When the time comes to apply for financial aid, your family’s income and assets are run through a formula at both the federal and the college (institutional) levels to determine how much money you are expected to contribute to college costs before you receive aid. This number is referred to as the expected family contribution or EFC.
In the federal calculation, your child’s assets are treated differently than your assets. Your child must contribute 20 percent of his or her assets each year, while you must contribute 5.6 percent of your assets. For example, $10,000 in your child’s bank account would equal an expected contribution of $2,000 from your child ($10,000 x 0.20), but the same $10,000 in your bank account would equal an expected $560 contribution from you ($10,000 x 0.056).
A custodial account is classified as a student asset. In contrast, Coverdell ESAs, 529 state savings plans, and prepaid plans are considered parental assets if the parent is the account owner (accounts owned by grandparents or other relatives or friends don’t count). Custodial versions of 529 plans and Coverdell ESAs are treated as parental assets. In addition, withdrawals from Coverdell ESAs and state savings plans used to pay the beneficiary’s qualified education expenses are not classified as parent or student income on the federal government’s aid form. This means that some or all of the money is not counted again when it is withdrawn; however, withdrawals from prepaid tuition plans are counted. Specifically, any distributions from a prepaid tuition plan reduce your child’s cost of attendance. As a result, every dollar that comes out of your prepaid tuition plan will reduce your child’s potential aid award by one dollar.
We are here to help
Trying to decipher which college savings plan is right for you can be enormously challenging. We are here to help you determine which savings vehicle best fits your financial situation—and, most important, your family’s needs. We know that family members play a primary role in your life and in your financial decisions. That’s why we always keep them in mind when we work with you to manage your wealth.
*The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that a college-funding goal will be met. In order to be federally tax-free, earnings must be used to pay for qualified higher education expenses. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10-percent penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.