There are several different types of education savings accounts that can be used to save for your child's future education expenses. The two main education savings account vehicles are Coverdell Education Savings Account and a 529 College Savings Plan. Many individuals also create Uniform Gift to Minors Act (UGMA) custodial accounts and provide funds directly to the child.
Here are a few things to consider about each of these methods:
Coverdell Education Savings Account
- Tax Advantage: Use after-tax dollars, but money in the account grows tax free, and no taxes on the distribution if used for education expenses
- Contribution Limit per Year: $2,000
- Income Restriction on Contributor, See latest IRS guidelines
- Very flexible investment choices and can reallocate the portfolio as often as desired (similar to a IRA)
- Distribution Restrictions: Any qualified education expense, including preschool through college (this includes elementary through high school)
- With a Coverdell, once the child reaches 18, the account control is given to the student, and they can do whatever they want with it, including withdrawing it and paying penalties
529 College Savings Plan
- Tax Advantage: Use after-tax dollars, but money in the account grows tax free, and no taxes on the distribution if used for qualified secondary education expenses
- Contribution Limit per Year: Varies by state, $100,000 to $350,000
- Income Restriction on Contributor: None
- Stricter investment choices and can only re-balance the portfolio twice per year
- Distribution Restrictions: Funds are limited to secondary institution expenses only
- The parent is the permanent account holder, and remains in control of the money for all time
UGMA Custodial Account
- A UGMA is a custodial account that is used to gift assets to minors
- They can also be UTMA accounts, or Uniform Transfer to Minors Act accounts
- The assets given are owned by the child
- Since the assets are owned by the child, they can impact the child's ability to receive financial aid in the future
- This type of account is beneficial to the giver for tax and estate reasons (avoiding the estate tax and income on the assets are paid at the child's tax rate)
- Distribution Restrictions: None, the custodian can sell the assets for the child's benefit at any time and for any reason, and the child can once he reaches 18 or 21, depending on the state
Which Education Savings Account is Best?
So which type of education savings plan is the best? Its a tough choice. Coverdells are great in that they can be used for all education expenses. However, some parents worry what their child will do with the money when they take control. A 529 plan avoids this, and it allows the wealthy to provide for their child's secondary education. A UGMA is less favored, but it allows the money to be used for essentially anything, and is not restricted to educational uses.
When I went to college, I couldn't qualify for any aid because I had assets in a UGMA. I'm grateful for the gifts I received, but there are consequences of them that were probably not foreseen when they were given. I know when it comes time to think about saving for any future child's schooling, I think I am just going to save money in a regular account in my own name, and write a check when the time comes. That way, my child could apply for scholarships and the like, and I have flexibility to use my money as I need for their entire childhood.
Readers, what are your thoughts? Have you ever used any of these types of accounts, or are you considering doing so?
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Another thing to consider regarding custody of the accounts is that colleges will often see student assets more as “fair game” than parental assets. For example, at my alma matter, expected student contribution would be something like 20% each year whereas expected parent contribution was probably 5% or less of asset value. That means that students who don’t have custody over college savings are more likely to get better financial packages (assuming the school determines those based on need).
I’m not sure how I feel about the child having access to the account at the age of 18. That just seems like a lot of responsibility for someone who might not be ready for that yet.
You can also use a combination of these accounts, assuming your child will be going to private schools. For example, save in a Coverdell for high school costs (which can cost a lot more than grammar school) and a 529 for college. Our income is still low enough that we are saving in our own retirement account (401k and IRA) but once we max those out, my next step is the coverdell.