What Account Should I Use for Education Savings?

In our last blog post, we discussed how much should be saved for education.

Once you reach the point where you are willing and able to save for education, what are the best vehicles to use? As always, it depends on your situation. Listed below are the most common mechanisms to fund education:

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• 529 Plan – 529 plans are state-sponsored retirement plans. Each plan is slightly different (with different fund options available), but they all operate in a similar fashion. There are no age limits or income limits to fund a 529 plan. One benefit is that they operate similar to a Roth IRA. As long as funds are used for educational expenses, the distributions are tax free (including earnings!). If a student receives a scholarship, funds can be distributed dollar-for-dollar from the 529 plan. In this case the earnings would be taxable as ordinary income to the account owner since the funds were not used for education (however, there would not be an additional tax penalty). One downside of a 529 plan is the taxation of a distribution if the funds are not used for educational purposes (other than the scholarship distribution listed above). If funds are distributed and used for other purposes, the earnings are taxed and penalized. No fun!

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• Coverdell (Educational Savings Account) – A Coverdell account operates similarly to a 529 plan. The taxation is the same – it grows tax-free as long as distributions are used for qualified educational expenses, but earnings can be taxable and penalized if distributions are used for
  other purposes. There are a couple of key differences between Coverdell and 529 plans. Coverdell funds must generally be used by the child’s 30 th birthday, and there is a $2,000 contribution limit per beneficiary. Contributions can also be limited if AGI (Adjusted Gross Income) crosses certain thresholds.

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• UTMA – An UTMA account is a bit different, as it’s not specifically for educational purposes. An UTMA account is an account opened by an adult custodian for the benefit of a child. The funds deposited into the account can be used for any purpose that’s for the benefit of the minor. The earnings in the account are taxed at the minor’s tax rate, which is often very low. One potential downside of an UTMA is that once the child reaches the age of 18, the account is fully owned by the child. They can do whatever they please with the assets in the account. Another factor to consider with an UTMA account is that the assets can significantly impact the minor’s ability to qualify for federal student aid, since the asset is in the child’s name.

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• Investment Account (in the parent’s name) – Sometimes, parents choose to use a regular investment account to fund their child’s education. These accounts are the most flexible of all the options listed on this page. There is no contribution limit, and funds in the account can be
  used for anything at all (and at any time). The downside is that capital gains and dividends will be taxed at the parent’s tax rate.

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• Roth IRA – Roth IRAs are an underrated educational savings tool. Within a Roth IRA, there are two components – cost basis and earnings. Cost basis is a fancy term for the amount contributed to the account over the years. In a Roth IRA, cost basis can be withdrawn at any time – tax free and penalty-free (the only exception would be with a Roth conversion – we will cover this in a later blog). The downside to using a Roth IRA is that you are dipping into retirement assets, dampening the compound interest that can have such a tremendous impact
  over the long-run.
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As you can see, there are multiple options for funding educational expenses. Which one makes the most sense for you? Contact one of our planners today!