College Savings Accounts
Here is an interesting and simple breakdown of different types of accounts to help you save for your children’s education. This is a great article and thought I would share it with our blog readers:
The high cost of a college education is enough to leave even parents with the best of intentions feeling bewildered. For most people, it’s not enough just to squirrel money away in a traditional bank savings account and expect it to generate enough interest to cover your children’s tuition, fees, and other college costs. Instead, you have to take advantage of special college savings accounts that are specifically designed for use by parents and students trying to set money aside for future educational expenses. Although some of your options closely resemble a traditional brokerage account, others are available only through specific financial institutions that are designated providers of these special accounts.
There are several different ways to save for college, and they’re not mutually exclusive, so you can mix and match them to come up with the best combination of savings vehicles for your needs. Below we’ll look more closely at three different options: custodial brokerage accounts, Coverdell Education Savings Accounts, and 529 college savings plans. Each of them has pros and cons in comparison to the others, but they all have something to offer.
1. Custodial brokerage accounts: The most flexible option — with the fewest incentives
The easiest way to save for college is to use what’s known as a custodial brokerage account. These accounts are much like regular brokerage accounts in that they give you access to the broadest possible range of investment choices. You can invest in stocks, bonds, mutual funds, exchange-traded funds, and a host of other investments through a custodial brokerage account.
What makes a brokerage account “custodial” is that an adult, usually a parent, holds the account for the benefit of a child who has not yet reached the age of legal majority in that particular state — typically age 18. The adult custodian is responsible for making all the investment decisions related to the account, and the funds must be used only for the benefit of the child named on the account.
Most custodial accounts allow parents to associate their child’s tax identification number with the account, which ensures that any taxable income the account generates is treated as the child’s taxable income. This can create a tax advantage because most children have lower tax rates than their parents. However, it’s important to understand that custodial brokerage accounts do not receive tax-free or tax-deferred treatment, unlike the alternatives listed below. (More details on this to follow.)
There are two big downsides to custodial brokerage accounts. First, for financial aid purposes, custodial brokerage account assets are generally treated as the student’s, requiring a larger percentage contribution before financial aid can kick in. Also, the parent is required to hand over the money in the custodial brokerage account when the child reaches the age of majority — and there’s no requirement that the child then use that money for educational purposes. If you don’t trust your child to do the right thing with the money you’ve saved, then a custodial brokerage account can backfire.
2. Coverdell Education Savings Accounts: Flexibility and tax savings — but small contribution limits
Coverdell Education Savings Accounts have many of the same advantages as custodial brokerage accounts, but with some additional benefits. Coverdell ESAs are accounts provided by regular brokers, and again, they allow you to invest in just about anything you could purchase through a typical brokerage account. In addition, so long as you use the money in the Coverdell account for qualified educational expenses — such as tuition, room and board, and fees and supplies required by your classes — then the income and gains on your investments will be free from tax.
However, there are some downsides to Coverdell ESAs. The biggest is that there’s a contribution limit of just $2,000 per year, making it difficult to save enough in the account to make a dent in the college costs that families typically face. Those limits are low enough that many financial institutions have scaled back on allowing customers to open Coverdell accounts, and some major providers have gotten rid of Coverdells entirely. Bear in mind that the limit applies per student, not per contributing person, so you can’t get around the limits by having grandparents or other relatives open additional Coverdell accounts in the student’s name.
There are also income limitations that you have to meet to make a Coverdell contribution. If your gross income is above $110,000 as a single filer or $220,000 as a married couple filing jointly, then you’re not allowed to make any Coverdell ESA contribution at all. Single filers with incomes between $95,000 and $110,000 or joint filers with income between $190,000 and $220,000 are allowed to make partial contributions.
Finally, Coverdell money must be used by the time the beneficiary turns age 30. There’s an option to change the beneficiary if the money isn’t needed, but otherwise, penalties can apply if the money isn’t used in a timely manner.
3. The 529: Big contribution limits and tax breaks — but limited investment options
The most commonly used college savings account is the 529 college savings plan. These accounts are offered by every state except Wyoming to facilitate college savings, and with contribution limits in the hundreds of thousands of dollars, 529s can hold more than enough money to fund the typical four-year education.
However, there are some limitations that people don’t like about 529 plans. First, each plan has only a limited menu of investment options to choose from. These are typically mutual funds, and depending on the state and financial institution providing the plan, the costs of using 529s can vary widely. Some 529 plans are so expensive that it doesn’t make sense to use them, while others are quite affordable.
Even so, the benefits of 529 plans are considerable. Distributions are tax-free as long as the money is used for qualified educational expenses. Tax reform extended the same favorable treatment to K-12 educational expenses that were previously reserved for Coverdell ESAs, further widening the potential uses for 529 plans. There’s no age limit on beneficiaries of a 529 plan, allowing someone to save the funds for continuing education or graduate school studies later in life. In addition, some states offer state income tax breaks to residents who use the state’s 529 plan.
Which college savings account is best for you?
A combination of these accounts can be the best way to maximize your college savings opportunities. Being able to invest in individual stocks by using a custodial brokerage account or Coverdell ESA is a huge advantage, but the large contribution limits available with 529 plans makes them popular as well. In the end, the best thing to do is to figure out how much you must save for college and then allocate those savings in whatever way stretches them as far as they can go.
This article was written by Dan Caplinger from The Motley Fool and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to firstname.lastname@example.org.