The average cost of college can be as much as
Several college savings plan options are available. Each offers certain advantages as well as potential tax and financial aid implications. From individual retirement accounts (IRAs) to an education savings account, here's what you need to know about different college savings vehicles.
529 college savings plans
These plans are typically administered at the state level, have high contribution limits and may offer a tax deduction,
Advantages of 529 plans
- No contribution limits. But note that contributions are considered gifts for federal tax purposes. Contributions above $17,000 must be reported on IRS Form 709 and will count against the taxpayer’s lifetime estate and gift tax exemption amount.
- Tax-deferred growth. This means you won't owe federal income tax on any interest or returns your contributions earn each year.
- Tax-free withdrawals. If you use the money to cover qualified college expenses and K-12 tuition costs, there will be no tax liability on your withdrawals.
- The ability to transfer a 529 plan to eligible family member. Let's say your first child gets a full scholarship to college but you have money sitting in a 529 plan. You can change the beneficiary to your younger child and use the money to pay for that child's college. You also could put the account in your own name or transfer it to another eligible relative.
- There are no income limits that could exclude a person from contributing. Some other plans have income limitations attached to them.
- There is no age limit for distributions. Some college savings vehicles have a designated age that funds must be used by.
Disadvantages of 529 plans
- Financial aid eligibility. The child's financial aid may be impacted, especially if the account is in their name.
- Limited flexibility. Remember to take into account the possibility of your child getting a full scholarship or having a family member contribute to their higher education costs. Depending on state requirements, you may not be able to use this money for non-education purposes. However, they still may be used to pay for housing expenses. When you use these funds for non-educational costs, there is typically a 10% penalty and income taxes on the earnings within these withdrawals. (This penalty is waived in the event of a death or disability.) If you want more flexibility because you are worried about the
possibility of the 529 plan going unused, consider an alternative.
Coverdell education savings accounts
The differences between a 529 plan and a Coverdell education savings account
However, one of the biggest differences between a 529 plan and Coverdell is that a Coverdell account has lower contribution limits, and your family must be below a certain income threshold to be eligible to contribute to a Coverdell.
- 2023 contribution limit: $2,000
Let's explore all of the differences side by side:
| || || |
|Income eligibility for contributor||Capped at $110,000 single and $220,000 married||None|
|Withdrawals||Qualified expenses for K-12 and college||Qualified college expenses and up to $10,000 for K-12 tuition|
|How long can contributions be made?||Contributions can be made up to age 18 except in the case of special needs beneficiaries||No restriction on age limit|
|Transferable to a family member||Yes||Yes|
|Tax status||Tax-free growth and withdrawals||Tax-free growth and withdrawals|
|Age limit for distributions||Must be used by beneficiary's 30th birthday except in case of special needs beneficiaries||No age limit|
|Contribution limit||$2,000 per year per child||Determined by state|
|FAFSA impact||Considered an asset of the contributor||Considered an asset of the contributor|
|Investment limits||None||Limited and controlled by the financial institution|
|Penalties||10% for withdrawals beyond qualified expenses||10% for withdrawals beyond qualified expenses|| |
Traditional & Roth IRAs
- 2023 IRA contribution limits: $6,500 under age 50; $7,500 age 50 or older
If you withdraw from an traditional IRA before 59½, you'd have to pay a 10% penalty on your withdrawals along with income taxes.
Advantages of using either type of IRA to fund college
The main advantage of using an IRA for funding college is the penalty-free withdrawals for qualified education expenses. This option can give your family financial flexibility if the student doesn't receive enough financial aid or scholarships to pay for college. This also may help your student avoid loans and debt after they graduate.
Disadvantages of using IRAs to fund college
There are downsides to using an IRA to cover college costs. Withdrawals will reduce your savings earmarked for retirement and you'll potentially miss out on the tax-free or tax-deferred growth on the amount you withdraw. You'll likely also pay income taxes on any earnings you withdraw, and you have to make sure you fully understand what specific education expenses qualify or you could face the 10% penalty.
Additionally, your withdrawals, even if qualified, may count as income if your family files the
General investment accounts
A general investment account, or a
- There is no cap on how much you can contribute every year, and you have more flexibility to withdraw whenever you want and for whatever purpose you choose, including paying for college.
There are tax implications depending on how long you've held assets in the account. You may have to pay short- or long-term
Using a general investment account to pay for college expenses comes with its own pros and cons. Similar to an IRA, you'll potentially sacrifice tax-deferred growth on the amount you withdraw. Another consideration is that the amount you withdraw will count as income and factor into your expected family contribution and financial aid package. Currently,
However, the upside of using a general investment account is that you don't have to worry about qualified education expenses. If you want to use the money to buy the student a car to get around campus or to or from their internship, you can do that. It doesn't just have to pay for tuition, fees or books.
Uniform Gifts or Transfers to Minors Act (UGMA/UTMA)
There are two main types of custodial accounts: UGMA & UTMAs. The main difference between
UTMAs can hold almost any asset type, including:
- real estate
- fine art
UGMA holdings are limited to:
- insurance policies
- investment assets like stocks, bonds or mutual funds
Each account has one designated custodian (typically a parent) and one designated minor beneficiary. However, the major drawback of custodial accounts is that the assets in these accounts are irrevocable, meaning the contributions made to the account belong to the beneficiary. You can't take them back or make withdrawals.
Benefits of UGMA & UTMA
- No limit on the amount you can contribute or no income eligibility limit.
- Contributions are considered gifts, subject to the annual gift exclusion. Beneficiaries who are under 19 years old, or under 24 and a full-time student, and whose taxable income is below $1,250 aren't subject to taxes. After that, the next $1,250 in unearned income is taxed at the child's income tax rate (any income in the account over $2,500 is taxed at the custodian's federal income tax rate).
- You also can use this account for any purpose—not just to pay for college—so it's much more flexible than an IRA, 529 or Coverdell college savings account.
Drawbacks of UGMA & UTMA
- They can affect financial aid. Currently, up to 20% of a child's assets count toward the
expected family contribution. Since a child is the owner of the UTMA or UGMA, the assets in this account likely will affect your family's out-of-pocket costs for college more than if the same amount of money were held in an account you owned as their parent.
- UGMA and UTMA accounts also must be terminated when the beneficiary reaches age 18 and 21, respectively, and the assets in the account must be distributed to the beneficiary. Keep this in mind if you intend to use this account as a college savings vehicle because once your child reaches these age thresholds, you can't control what they do with the assets in the account.
Permanent life insurance & trusts
Permanent life insurance features what's known as
With a trust, you can structure it any way you choose, including requiring that distributions only be used for education. A trust allows you to have more control over assets contained within the trust, how they are invested and how they are distributed. You can establish qualified transfers that generally do not affect beneficiaries' annual or lifetime exclusion, which is the maximum amount you can transfer to someone else as a gift.
Depending on how much you gift a child or family member, how you structure the trust, and the beneficiary's access to the trust, it may affect financial aid in varying ways. For example, the value of the trust may restrict the child's eligibility for need-based financial aid altogether.
Getting a head start on saving for college
The way you choose to save for college will depend on your savings goals and the level of financial flexibility your family requires. Contribution limits, tax consequences and rules around qualified distributions vary by each account. A