College Savings: The Basics You Need to Be Prepared
Key facts
- As college costs continue to rise, families must plan ahead to make college affordable.
- Options include savings, investments, financial aid and student loans.
- Education-specific savings and investment accounts offer special features to make saving for college easier.
Saving for college keeps many parents up at night. How much is enough, and will they be able to afford their children’s dream schools? The bottom line is that it is never too early to start putting money aside, and opening a 529 plan is a popular way to grow your savings in a tax-advantaged account.
As college costs continue to rise, families are worrying more about paying the bills for their children’s education. Tuition continues to rise, and even the relatively more affordable option – in-state tuition at a four-year public school – is outpacing inflation by 2%. While some students will have to rely on financial aid and student loans to pay their expenses, these options aren’t ideal. It isn’t easy to start post-college life with significant debt.
Many families are opting to start setting aside money for education when their children are quite young. In addition to standard savings accounts and investments, there are a variety of college savings plans that are specifically designed to help contributions grow more quickly.
College Costs: More Than Just College Tuition
When researching the costs associated with a college education, you are likely to come across the acronym TFRB. This stands for tuition, fees, room and board, which are considered the standard line items you can expect to see on your bill.
There are other education expenses not included in this amount. For example, your student may have to travel long distances to and from school. You will be responsible for purchasing textbooks each semester, and many specialized classes require additional equipment.
Finally, your student is sure to need a personal computer. Depending on her major, you might discover that a basic model won’t meet her needs. All of these items add thousands to the bottom line amount you will pay.
College Savings Options
If you choose to put money aside in an account specifically designed for college savings, you have a few options. Plan details vary, and the best choice will depend on your family’s circumstances and your student’s needs. The most popular savings plans include the 529 college savings plan, custodial accounts (UGMA/UTMA), and the Coverdell ESA program.
The 529 college savings plan is a tax-advantaged account specifically designed to fund secondary education expenses. Each state designs and maintains its own version of the plan, and eligible investors can participate in almost any state’s plan, depending on which investment options, fee structures, and management methods they prefer. Contributions to a 529 plan grow free of federal taxes, and some states offer tax benefits as well. Withdrawals from a 529 account do not incur taxes, as long as funds are used for qualified education expenses at an eligible institution. The individual who opens the account maintains control of the money until it is withdrawn, and beneficiaries can be changed without incurring federal income tax or penalty if the new beneficiary is an eligible family member of the original beneficiary. This account is a good choice for families that want to save a sizable amount for secondary education expenses, since the maximum contribution can range from approximately $200,000 to $500,000 depending on the plan.
Custodial accounts, known as UGMA or UTMA accounts, are opened by an adult as a gift or in trust for a minor child, the beneficiary. When the beneficiary reaches the age of majority, she becomes the account owner and can take withdrawals for any purpose. There are limited tax-advantages on earnings, and the beneficiary cannot be changed once the account is opened. Withdrawals from this account are not restricted to educational expenses.
Coverdell ESA accounts are sometimes referred to as Education IRAs. They are specifically designed to offer tax savings on funds set aside for education purposes, including elementary, secondary school, and higher education costs. Some families choose this option for the lower fees and wider range of qualified expenses. However, Coverdell ESA does come with income limits and contribution limits, which makes it difficult to solely rely on an ESA for all education expenses.
This table examines the primary differences between the three most common choices:
| Key Features | 529 College Savings Plan | UGMA/UTMA | Coverdell ESA |
| Changing Beneficiaries | Account owner can change beneficiary without incurring federal income tax or penalty if the new beneficiary is an eligible family member of the original beneficiary | No change permitted | Account owner can change beneficiary, subject to restrictions |
| Account Ownership | Account owner | Custodian until beneficiary reaches the age of majority, then beneficiary | Custodian; in some states only until beneficiary reaches the age of majority, then beneficiary |
| Taxes on Withdrawals | No, if used for qualified educational expenses | No, for the first $1,050 of account income, or less if the beneficiary has earned income | No, if used for qualified educational expenses |
| Federal Tax on Earnings | No | None for the first $1,050 of account income. Income between the first $1,050 and $2,100 of account income will be taxed at the beneficiary’s rate. Income after the first $2,100 of account income will be taxed at the custodian’s rate. | No |
| Annual Contribution Limit | None, though gift taxes may apply over $14,000* | None, though gift taxes may apply over $14,000* | $2,000 per beneficiary per year |
| Maximum Contribution Amount | Approximately $200,000 to $500,000 – total per beneficiary, depending on limits placed by individual state programs | None | None |
| Income Limits for Participation | None | None | $110,000 (single), $220,000 (married filing jointly) |
Source: Wealthfront College Savings Whitepaper
*The gift tax exemption limit is reviewed annually and is subject to change. The exemption is $14,000 in 2016.
Disclosure
Nothing in this article should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This article is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Financial advisory services are only provided to investors who become Wealthfront clients.
This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.
For information on any 529 college savings plan contact the plan provider for details on the investment objectives, risks, charges, expenses, and other important information included in the Plan Description and Participation Agreement; read and consider it carefully before investing.
Please Note: Before investing in any 529 plan, you should consider whether you or the beneficiary’s home state offers a 529 plan that provides its taxpayers with favorable state tax and other benefits that are only available through investment in the home state’s 529 plan. You also should consult your financial, tax, or other advisor to learn more about how state-based benefits (or any limitations) would apply to your specific circumstances. You also may wish to contact directly your home state’s 529 plan(s), or any other 529 plan, to learn more about those plans’ features, benefits and limitations. Keep in mind that state-based benefits should be one of many appropriately weighted factors to be considered when making an investment decision.
Earnings on nonqualified withdrawals are subject to federal income tax and may be subject to a 10 percent federal tax penalty, as well as state and local income taxes. The availability of tax and other benefits may be contingent on meeting other requirements.