College Savings Plans: 4 Account Types

What is a College Savings Plan?

A college savings plan is a way to put money aside for a child’s education with some help from Uncle Sam in the form of a tax break. Money goes into a college savings account after-tax, just as in a regular investment account, but the interest and gains on that money can come out later at a low tax rate or free of taxation altogether. That means compounding your investment tax-free, which can add a lot to what you will have available to pay the college bills when they roll in.

To get those tax breaks, there are some rules to follow and some limitations, which differ among the four types of accounts.

College Fund Account Types

The four most common types of college savings accounts are:

1. 529 Education Savings Accounts
2. Coverdell Education Savings Accounts
3. Custodial Accounts for a Child
4. Roth IRAs

529 College Investment Plans

A 529 Education Savings Account (formerly known as a Qualified Tuition Plan) is a state-sponsored investment vehicle that comes in two types:

• Prepaid tuition plans that are usually associated with specific state schools.
• Education Savings Plans sponsored by each state, which can be used at different schools within or even outside of that state.

Investment options are spelled out for each state’s plans and fees will vary from state to state. All 50 states plus the District of Columbia offer 529 Education Plans.

529 Plan Rules: Contributions & Eligibility

Anyone can contribute to a 529 plan and contributions are not limited, though if greater than $16,000 in a given year, they can be subject to the gift tax.

Benefits & Drawbacks to a 529 Plan

Pros:

• There are no income restrictions or contribution limits.
• Withdrawals are tax-free if used for qualified education expenses.
• Plans can be transferred to another child in the family.
• Plans can cover expenses for secondary education as well as college and can be used to pay for tuition, fees, room & board, books & supplies, computer equipment, or to pay down student loans.
• A 529 plan be purchased through financial advisors or directly through your state.

Cons:

• The available investment options are limited to what the state offers you.
• Details of the plan differ from state to state.
• Funds used for non-qualified education expenses are subject to taxes on income and gains plus a 10% penalty.

Coverdell Education Savings Account

Originally called Education IRAs and named for the Georgia Senator who sponsored them, Coverdell Education Savings Accounts are federally-authorized accounts for college savings.

Coverdell Rules: Contributions & Eligibility

To be eligible to open a Coverdell Education Account, a parent or donor cannot have a modified adjusted gross income (MAGI) greater than $110,000, and contributions are limited to $2000 per student per year.

Benefits & Drawbacks to a Coverdell Account

Pros:

• Withdrawals are tax-free if used for qualified education expenses.
• Plans can be transferred to another child in the family.
• Multiple relatives can contribute to a single Coverdell account, subject to the $2000 contribution limit for all donors combined.
• Coverdell accounts allow for education expenses other than just college.
• Coverdell plans can invest in any public securities.

Cons:

• Contribution limits are much lower than for other types of custodial accounts and education savings plans.
• Contributions are also not permitted from individuals with incomes over the stated limit.

Custodial School Savings Account

Under the Uniform Gift to Minors (UGMA) and Uniform Transfer to Minors (UTMA) Acts, adults may set up and manage custodial accounts on behalf of their children. The money in custodial accounts is managed by the custodian, though it belongs to the child named on the account. It may be withdrawn for any purpose before the child reaches the age of majority as long as it is used to benefit the child. Once the child reaches the age of majority, the money reverts to the child for any use they see fit.

Custodial accounts are not tax-free but do receive preferred tax treatments, which allow the gains on the accounts to be reported on the adult’s tax return or the minor’s, whichever is more advantageous.

Custodial Account Rules: Contributions & Eligibility

Any adult can open a custodial account for any minor. There are no income limits or restrictions on custodial accounts, but contributions are viewed as gifts and may therefore be subject to gift tax if they are above $16,000 (as of 2022) in any given year.

Benefits & Drawbacks of a Custodial Savings Plan

Pros:

• Unlimited contributions are permitted.
• There are no income restrictions on donors.
• Accounts can potentially take advantage of the lower tax rate of the minor.
• Money can be used for any purpose benefitting the minor.

Cons:

• Gains are not totally tax-free.
• Money becomes the property of the minor upon contribution and is irrevocable. It reverts completely to the minor upon reaching majority age and can be used at that time for any purpose they desire.
• Assets in custodial accounts can affect financial aid eligibility

Roth IRA

Roth IRA accounts were designed primarily as retirement savings vehicles, but they can be used to save money for any purpose and the earnings are tax-free if the account owner fits within contribution and eligibility rules.

Roth IRA Accounts: Contributions & Eligibility

Roth IRA’s accrue tax-free earnings if the account owner withdraws after age 59 ½ and has had the account longer than five years. But for qualified expenses including education expenses, the IRS allows tax-free withdrawals prior to that age. As such, one or both parents can use a Roth IRA to save for college expenses on a tax-deferred basis. There are spousal Roth IRAs available for non-working spouses as well.

Note: While it is not very common, you can also open a Roth IRA in your child’s name as a Custodial Roth IRA account, provided they meet the income qualification of $6,000 per year.

Benefits & Drawbacks of a Roth IRA as a College Savings Account

Pros:

• Withdrawals can be used for education prior to age 59 ½ and for any purpose beyond that age.
• Qualified withdrawals are tax-free.
• Investment options can be any public securities, funds, or bank products.
• You can use the money for anything else if your child doesn’t go to college.

Cons:

• Contributions are limited to $6,000 per year until age 50 and $7000 per year after that.
• Contribution limits are limited even further if your income is over $129,000 and you become ineligible to contribute at all if your income is over $144,000 in 2022.
• Non-qualified withdrawals are subject to tax on gains plus a 10% penalty.

Which College Savings Plan Is Best For You?

The four types of accounts mentioned above all offer tax incentives to investors who are accumulating money for their children’s education. The key differences between education savings accounts are how much (and whether) you are allowed to contribute, whether the money reverts to the parent or the child if not used for education, and whether the investment options are limited.

A quick summary comparison of the four types of plans is shown below.

	529 Plan	Coverdell ESA	Custodial Account	Roth IRA
Contribution Eligibility	Anyone	Earnings restriction	Anyone	Earnings restriction
Contribution Limits	Unlimited	Limited	Unlimited	Limited
Asset Ownership	Parent	Parent	Child	Parent
Investments	Limited Choice	Any	Any	Any
Use the Money for Another Child	Yes	Yes	No	Yes

Among the four types of accounts available, virtually any parent can set up one or more of these accounts to take advantage of tax-free earnings when saving for a child’s education. Once you decide, be sure to check all the rules and qualifications to make sure it works for you. Some plans have additional considerations for special needs students as well.