A Comparison of College Savings Plans
Posted by Jill on September 23, 2009
It is never too early to start thinking of saving for college. Yesterday, we talked about things to consider when developing a college savings plan. Today we’ll review various college savings options in more detail.
College Savings Plan Considerations
When choosing a savings plan, you should be aware of the following:
- Maximum contribution per year: Some savings vehicles limit the amount of money you can invest per year.
- Ownership restrictions: You may be able to put the account in your name or your child’s name.
- Financial aid impact: Some accounts are considered as assets for financial aid purposes, while others are not.
- Tax implications: Accounts may give a tax break at either contribution or distribution.
529 College Savings Plans
- Special characteristics: 529 plans are administered by states and help you qualify for both state and federal tax breaks. Account specifications differ from state to state. Many states (like Ohio) allow anyone to invest in their plan, but only offer state tax breaks to their own residents. 529s can be established for people of all ages and can pay for any post-secondary education expenses, including graduate or continuing education for a student of any age.
- Maximum contribution per year: None. Many states will cap total contributions somewhere around $300,000 per beneficiary. However, you should be aware that contributing more than $12,000 per year could trigger gift tax implications.
- Ownership restrictions: Account owners are those who open and fund the accounts, as well as choose the investments. Beneficiaries are those whose college expenses are paid by the account distributions. One person can be the owner on multiple accounts, each with one beneficiary. One beneficiary can benefit from multiple accounts. Each account can only have one beneficiary at a time, though the beneficiary can be changed. This is helpful if you open an account before your child is born, or want to transfer remaining funds if a child does not go to college or finishes college without spending the entire balance.
- Financial aid impact: 529 plans with the financial aid applicant as a beneficiary are considered in the financial aid process. All funds are considered available to help fund the expected family contribution.
- Tax implications: 529 contributions are often deductible for state income tax purposes when using home state plans. Distributions for qualified education expenses are tax-free. Distributions for other purposes will trigger a federal capital gains tax on any earnings equal to the owner’s tax rate plus a 10% penalty.
Coverdell Accounts
- Special characteristics: Coverdells are established for children under 18 at the time of funding. All funds must be spent or transferred to another beneficiary before the initial beneficiary reaches 30, or a penalty is assessed.
- Maximum contribution per year: $2,000 per beneficiary, even in multiple accounts with different owners.
- Ownership restrictions: In 2009, account owner income must not exceed $220,000 for owners who file joint taxes and $110,000 for single filers.
- Financial aid impact: All funds are considered available to help fund the expected family contribution.
- Tax implications: No deduction or exclusion for contributions. Distributions for qualified education expenses are tax-free. Distributions for other purposes will trigger a federal capital gains tax on any earnings equal to the owner’s tax rate plus a 10% penalty.
Roth IRAs
- Special characteristics: As you probably know, Roth IRAs are actually retirement accounts that allow for distributions before retirement age in certain situations. Roth IRAs can be attractive for education funding because there are no set beneficiaries and they do not impact financial aid awards. However, education distributions can be subject to taxes, unlike distributions for other purposes. Roth IRAs should not be used for education funding without careful consideration of the impact on your general financial health.
- Maximum contribution per year: $5,000 per year in 2009.
- Ownership restrictions: Eligibility to establish a Roth IRA phases out above a certain income ($166,000 for taxpayers filing jointly in 2009).
- Financial aid impact: Retirement accounts are not considered assets for financial aid purposes, meaning they will not reduce the amount of aid your student is eligible for.
- Tax implications: When used for qualified expenses, Roth IRA distributions will be subject to income tax but NOT the 10% penalty for non-qualified distributions. If the account owner is 59 ½ at the time of distribution, no tax or penalty applies.
Other Accounts
In addition to the vehicles above, you could choose to use a simple high-interest savings account or a taxable investment account. Keep in mind that these options may limit growth and/or tax benefits.
Wrap-up
Saving for college in advance is always a good idea, regardless of what vehicle you choose to use. With a little planning, you can minimize taxes, maximize financial aid, and help your child pay for college with as little damage to your wallet as possible.
While 529 accounts are the most common and make the most sense for the average investor, every option mentioned here can make sense in a particular situation. Consult your own financial advisor or a college savings expert to develop a college savings plan tailored to your financial situation.
You didn’t mention Savings Bonds (I and EE). They are a good option as you get closer to the college years because they don’t have a potential for principal loss.
Advantages:
– Gains not taxed if used for education.
– Principal protection
– Doesn’t have “fees” associated with 529 plans
Disadvantages:
– Currently have low rates of return
– Max of $5,000 per year
– Penalties for early withdrawal
http://www.treasurydirect.gov/.....glance.htm
@Brian H
You’re right I didn’t mention them – mostly because they are not solely used for education funding. There are also many restrictions such as have to be issued in both parent and child’s name, etc. But they can definitely be a good options as well. Thanks for the comment.
Hi Jill,
Overall, a good article outlining the pros and cons. However, I think that you may have an error/unclear portion with regard to the following – I mention this not in a confrontational way, but for clarity (and I would be interested if you have something showing me to be wrong). The section is this:
“Ownership restrictions: In 2009, account owner income must not exceed $220,000 for owners who file joint taxes and $110,000 for single filers. ”
If you look at the IRS publication below, I think that you mean this to be a *contribution* restriction, not an ownership restriction. This is important, for example, in my situation where our combined income exceeds 220K and I own the Coverdell account – consequently, neither my wife nor I can contribute (although we can still *own* the account). However, my Mom is retired and makes less 220K, so she *can* contribute 2K to the Coverdell. It would be up to us whether we would wish to make a tax-free gift of around 2K to my Mom in any one year.
My point is that the income restriction is on the contribution, not the ownership.
You can see the IRS’s publication on the Coverdell at: http://www.irs.gov/publications/p970/ch07.html
One other thing that you may have mentioned – it’s not incorrect, but it is an omission – is with regard to the Roth IRA. Specifically, if your income exceeds 166K, you can’t contribute to a Roth, but you CAN contribute to a regular IRA and then roll it over into a Roth in 2010, regardless of income.
http://www.rothira-advisor.com.....ax_cut.htm
@Average Joe
You make very good points on both. The Roth IRA conversion is a little out of the scope of this article, but you are correct in saying that a regular IRA rollover is a good strategy for those above the income limits.
In terms of the Coverdell ownership, you usually have to make a contribution to open the account, which is why I kind of lumped the two together – to open a new account with an initital contribution, you must be under the income limits. But yes, if you opened the account and made initial contributions in a year you were under the income limits, other people could continue contributing in future years. Alternatively, if you could find an institution that would let you open without contributing, you could do that and have other people make the contributions.
Again, the gifting (tax-free) to your mother and then having her make the contributions is a little out of scope but a good strategy.
Thanks for your comment, I appreciate the clarification for other readers!