College Savings Plans: The Ultimate Guide - MagnifyMoney

College Savings Plans: The Ultimate Guide

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You know college is expensive, and you’re ready to start saving. But how do you review all the available college savings plans and find the plan that’s right for you and your family?

Don’t worry — we’re here to deliver the low-down on saving for college so you can find the right plan today to fuel an education tomorrow.

529 accounts

529 college savings plans — which the IRS officially calls Qualified Tuition Programs (QTPs) — are the most popular way to save for K-12 and college education expenses. With 529 accounts, your investments grow tax-deferred. Then, when you’re ready to use funds for qualified educational expenses, you can withdraw funds tax-free.

You can use your educational wealth to pay for a wide range of education types, including tuition at K-12 private schools, trade schools, vocational schools and colleges. Want to pay for more? You’re in luck. You can also use your 529 funds to cover room and board, books, supplies and other related expenses, including computers and internet access.

You can choose from two different types of 529 accounts: education savings plans and prepaid tuition plans.

529 plans: Education savings plans

Education savings plans are offered on a state-by-state basis. Contributions to these plans are considered gifts by the IRS, and you can sock away up to $16,000 per year in 2022 without triggering the gift tax.

States set their plans, which means the aggregate maximum you can contribute varies by state. For example, Missouri’s plan has a high aggregate limit of $550,000, whereas Georgia and Mississippi have plans that max out at $235,000.

Pros Cons
  • Contribute up to $16,000 per person per year
  • Donors can be friends and family
  • No income restrictions
  • Potential to deduct contributions on state taxes
  • Contributions may decrease financial aid eligibility
  • No federal income tax deduction for contributions
  • Investment options are limited to the plan’s offerings
  • Investments may lose value

529 plans: Prepaid tuition plans

If you want to lock in today’s tuition rates for future education, you’ll want to look for a prepaid tuition 529 plan. Unlike state-based 529 plans, prepaid tuition plans don’t have investments inside the account. Instead, you’re paying installments toward a lump-sum dollar amount. And should your child decide not to attend college, the prepaid tuition plan may let you transfer the funds to another child.

Pros Cons
  • Lock in current tuition rates for the future
  • No potential for investment losses
  • Most plans are guaranteed to keep pace with tuition
  • Fund can’t be used for college room and board
  • Funds can’t be used for K-12 education
  • Canceled plans will likely incur a cancellation fee

Coverdell Education Savings Account (ESA)

A Coverdell Education Savings Account (ESA) is a custodial account specifically for educational expenses. With a Coverdell, you designate an account beneficiary, and the funds can only be used for the named person. And unlike a 529 plan where beneficiaries can be of any age, a Coverdell can only benefit someone under 18.

On the taxes front, you won’t be subject to capital gains or federal taxes on your gains while in the account, and withdrawals are federal income tax-free when used to cover qualified higher education expenses. We go into more detail on Coverdell ESAs in our guide to custodial accounts.

Pros Cons
  • Eligible for K-12 and college expenses
  • Broader investment options than 529 plans
  • Tax-free growth and distributions (subject to restrictions)
  • Contributions must be made in cash
  • Low annual contribution limit ($2,000)
  • Those with incomes over $220,000 are ineligible

Custodial accounts

Uniform Gift to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts are custodial accounts that may help pay college expenses that other college savings accounts don’t cover. However, these accounts have a pitfall: Once a minor becomes an adult, the account holder can spend the money on whatever they want.

Pros Cons
  • UGMAs can hold a wide variety of investments
  • UTMAs can hold real estate and tangible items
  • All states now offer UTMAs and UGMAs
  • Can’t transfer UGMA/UTMA to another beneficiary
  • Can’t specify how money can be used
  • Can reduce eligibility for need-based financial aid

Savings bonds

Believe it or not, you can use savings bonds as a sort of tax-advantaged way of saving for college. If you buy Series EE or Series I savings bonds and redeem them for education expenses, you can exclude the interest from your taxable income in the same year of redemption. Of course, you’ll have to submit IRS Form 8815 with your income taxes to get this exemption.

Before you get too excited, however, there are five specific criteria the government requires that you meet to get this tax break. The bonds must have been issued to someone 24 or older, not in the minor child’s name too.

Pros Cons
  • Potential tax savings by reducing your taxable income
  • Low-risk investment
  • Must meet all five criteria to get the tax break
  • Not eligible for those who file “married filing separately”
  • Income limits vary year to year

Roth IRA

While not typically used as a college savings plan, a Roth IRA can help you save for college when you’ve maxed out a 529 account.

A Roth IRA lets you save after-tax money toward retirement for those who meet the income limits. For educational expenses, there’s a fringe benefit, too: Withdrawals for qualified educational expenses aren’t penalized, but they will be subject to income tax.

However, there’s an additional fringe benefit when using a Roth for education savings: You can use any money not spent on education for retirement.

If you’re considering a Roth for education savings, explore how a Roth IRA compares to 529 plans.

Pros Cons
  • Money not used for education can be used for retirement
  • Higher contribution limit than Coverdells ($6,000 for 2022)
  • Won’t impact financial aid eligibility like a 529 plan
  • No tax deduction for contributions
  • No early withdrawal penalty, but withdrawals are taxed
  • Annual contribution cap is much lower than a 529 plan

Taxable brokerage account

When you’ve maxed out your tax-deductible options for college savings, a taxable brokerage account can help you save more. You won’t face pesky contributions or income limits, and you can open an account at any online brokerage of your choice. However, you could take a hit on financial aid eligibility. Colleges will count up to 5.64% of assets in a parent’s and up to 20% of assets held in a custodial brokerage account as assets available for education expenses.

If you’re new to brokerage accounts, we’ll help you get up to speed with our brokerage account guide.

Pros Cons
  • No contribution limits
  • No limit on the use of funds
  • Wider range of investment options versus 529 plans
  • No special tax treatment
  • Earnings subject to capital gains taxes
  • Potential to reduce financial aid eligibility

Savings accounts

Savings accounts should be your last option for college savings. Compared to other options with more significant tax benefits and growth potential, a savings account can’t compete. However, if earning a competitive rate is important to you, consider using a high-yield savings account to get the best rates.

Pros Cons
  • Tax-free withdrawals
  • No contribution or income limits
  • Money can be used for any purpose without penalty
  • Interest earnings are taxable
  • Lower interest rates than other college savings options
  • Savings rates might not keep pace with inflation

The wide variety of college savings plans available can help you save for educational expenses and potentially help a child avoid the pain of student loans. And remember: If you need help finding the ideal college savings account for your circumstances, you can always connect with a financial advisor for help.

Frequently asked questions

It depends on the plan, as 529 plan contributions are typically only tax-deductible on state income taxes. For example, Illinois residents can deduct 529 plan contributions up to $10,000 annually ($20,000 for married couples filing jointly). Unfortunately, there’s no federal income deduction for 529 plan contributions.
You should save as much as possible within your budget and without compromising your retirement savings. You only get one shot at saving for retirement, but if your child’s education savings fall short, they can always supplement with student loans and a part-time job.

The “Find a Financial Advisor” links contained in this article will direct you to webpages devoted to MagnifyMoney Advisor (“MMA”). After completing a brief questionnaire, you will be matched with certain financial advisers who participate in MMA’s referral program, which may or may not include the investment advisers discussed.