Types of College Savings Accounts

College Savings Options

If you want your children to go to college, you need to save. Period. That’s the easy part. Harder is where and how much.

People worry that they’re going to lose out on financial aid if they save. Yes, your savings will add a small amount to your EFC (or SAI starting next year). However, the small amount of financial aid you give up is more than offset by the additional choices your child will have because you’ve saved. Assets such as college savings add 5.64% of their value to your EFC/SAI. That means that every $1,000 of savings will increase your EFC/SAI by $56.40, leaving you ahead by $943.60. In addition, research has shown that students whose families have saved for college– even very small amounts– are more likely to enroll in and graduate from college than those with no savings.

This section will dive into the range of college savings options available to parents. Just remember that the time window for funding and growing your college savings is short, so the sooner you get on it, the sooner your money gets to work for you. Here’s a breakdown of the most common college saving options including:

• 529 Plans

• Coverdell ESAs

• Bonds

• Roth IRAs

• Parent-Owned or UTMA

• Life insurance and annuities

What is a 529 Plan?

For most people, 529s are the best option so I’m talking about them first. I’ll cover the others later. Why should you first consider a 529 as your preferred college savings vehicle? First, a 529 plan is a tax-advantaged college savings plan operated by a state or educational institution. 529 refers to Section 529 of the IRS code which created these plans beginning in 1996.

529 college savings plans offer several types of tax advantages:

• Funds in the accounts grow tax-free

• As long as they are withdrawn for qualified expenses– generally tuition, room, board and certain supplies– the withdrawals are also tax-free

• Many states also offer their residents a tax benefit for investing in the state’s 529 plan. For example, Oregon offers a tax credit of $150 (single filer) or $300 (married filing joint) for contributions each year.

Nearly every state offers a plan, and you can choose any state’s plan to invest in. Whichever plan you choose, you can use the funds at any qualified higher education institution. For example, you can live in Oregon, invest in Virginia’s plan, and send your student to college in California.

There are two types of 529 plans:

• Savings Plans work a lot like an IRA or 401(k): you choose what to contribute and how to invest it. Your account balance will fluctuate based on your contributions and market performance.

• Prepaid Plans let you prepay your state’s public school tuition, essentially locking in today’s tuition rates. Generally they also let you convert your savings to use at a private or out-of-state institution. Typically you purchase “units” of college tuition at today’s price (a “unit” might equal 1/100th of the cost of one year’s tuition); those units maintain their relative value as tuition increases.

Savings Plans are far more common than Prepaid Plans.

I’ve used the term “qualified” a few times here, so here’s context on what “qualified” means. With a 529 Savings Plan, “qualified educational expenses” include tuition, mandatory fees, room and board, textbooks, supplies and other equipment that is required for enrollment. Prepaid plans cover a smaller list; check the plan’s document for details. One potentially significant expense that is not “qualified” is the cost of getting to and from school. Computers may or may not be qualified. Student loan payments and entertainment (sports tickets, fraternity/sorority dues, etc.) are also not qualified.

Qualified institutions are those for which you can withdraw funds tax- and penalty-free to pay for qualified expenses. A list is available here— and note, the list is not limited to US institutions.

Later we’ll get into the details of choosing a plan and opening an account.

Coverdell ESA

Given the lower contribution limit—$2000 annually per beneficiary—many people wonder why anyone would bother with a Coverdell ESA, compared with a 529 plan. Here’s a quick overview; maybe you’ll find that a Coverdell ESA should be part of your college savings planning as well.

Coverdell ESAs work a lot like Roth IRAs and 529 plans: You contribute after-tax money to them, and future withdrawals are tax-free. Like 529 plan withdrawals, Coverdell ESA withdrawals are not counted as income in aid formulas. So, what’s different? Several things:

• Qualifying expenses: Funds in Coverdell ESAs can be used for K-12 expenses, in addition to college expenses. For K-12 expenses, a qualifying school is any elementary or secondary school as defined under applicable state laws—which may include home schooling. If you have a child in private school, or intend to send one to private school, a Coverdell ESA can be a big help. Likewise if you intend to home school, you may be able to use a Coverdell ESA to cover some of the costs you incur.

• Investment choices: Coverdell ESAs are self-directed investments. That means you open the account and you choose the investments. Many custodians, including Schwab, USAA, State Street Bank, Scottrade, TD Ameritrade, Capital One and more, offer low-cost Coverdell ESAs.

• Income limits: Joint filers need MAGI below $190,000 in order to contribute to a Coverdell ESA. If your income is above that threshold, you can gift money to your child who can then open the account.

• Beneficiary changes: Coverdell ESAs let you change the designated beneficiary to any other family member who is under age 30.

Donors and custodians may impose restrictions or rules so if you think a Coverdell ESA might be a good fit for your family, be sure to read all the fine print before investing.

College Savings Bonds

Many parents and grandparents purchase education savings bonds– series EE or series I bonds– to pay for college. These bonds are tax-free within some limits, and it’s not uncommon for families to find out too late that they’ve landed outside the limits.

Here is how these bonds work: You purchase the bond at face value, with a minimum purchase of $25 and a maximum of $10,000 (with some variations to that). That means a $25 bond costs $25. The bonds earn interest which is compounded semiannually for up to 30 years. The interest is accrued, i.e., not paid out, until you cash in the bond, though it is taxable unless the bond is used for qualified higher education expenses. EE bonds earn a fixed interest rate (currently 0.10% as of November 2021). I bonds have a combination of fixed interest rate and inflation adjustment. You can pay taxes on the interest annually, or if you fall within the income limits (AGI of $93,150 for single filers in 2017, $147,250 for married filing joint), defer the taxes. Like distributions from a 529 plan, as long as the bond is redeemed to pay for qualified higher education expenses, the interest is not taxable.

Here’s the catch: As soon as your income exceeds the thresholds, the interest earned by the bonds is taxable to you. Not only that, but the interest is reported as income on your tax return which, if this occurs in a FAFSA year, will raise your EFC. It’s not at all unusual for a family to purchase these bonds for a baby and then discover once they reach their teen years that their household income has grown beyond the threshold and suddenly the bond interest is taxable. And once you report the interest annually, you have to keep reporting it annually, so even a one-time bump in income will throw the savings bond strategy off.

Fortunately, there’s a remedy: You can roll the bonds into a 529 account. Keep in mind, though, that the same income limits apply to rollovers. So if your income is on an upward trajectory, making that change sooner rather than later is imperative. There are some specific steps to follow to ensure that the rollover is qualified (not taxable), so you’ll want to contact your 529 plan for detailed instructions. And of course consult your tax advisor.

Treasury Direct, the Treasury’s website, has additional information about series EE and I bonds, tax treatment and other requirements.

While I’m on this topic, most college savings vehicles other than 529s have some form of income cap. Coverdell ESA accounts have income limits for contributions, for example. Families beginning to save for college should take a long view when thinking about how to start saving in order to avoid unexpected taxes or penalties or find themselves in need of a new college savings plan.

Qualified Savings Options Compared:

Roth IRA for College

One of the popular non-qualified options is a Roth IRA. That’s because retirement accounts do not count as assets in the aid formulas. However, if you withdraw from a Roth during a FAFSA income year, the withdrawal is added to your income. This hurts far more than the asset would have in the formula.

While you do get tax-free growth and distributions, the big question for anyone considering using a Roth for college should be, “Will I have enough money left for retirement if I spend my retirement savings on college?”

• “It’s not an asset on the FAFSA!”

• Yes, but it’s income when you withdraw it

• Benefits: Tax-free growth and distributions

• Drawbacks:

  • Annual contribution limit

  • Withdrawal added back to income on FAFSA

  • If you spend your Roth IRA for college, do you have enough other retirement savings?

Taxable: Parent-Owned or UTMA

Taxable accounts are also popular. Accounts owned by parents get better treatment in the aid formulas than do UTMAs, which are the student’s asset on the FAFSA. The big gotcha with a taxable account is that realized gains when the account is spent down for college add to income and thus hurt the student in the formula.

• Taxable investment account is an asset of its owner for financial aid

  • Realized capital gains, dividend distributions generate income on FAFSA/CSS Profile

• UTMA is student asset on FAFSA

  • Can be rolled to 529 for parent asset treatment

  • Watch for capital gains in FAFSA income years

Using Life insurance to Pay for College

Unfortunately, many commissioned insurance agents will (falsely) position policies and annuities as a college savings vehicle on the basis that they don’t have to be included on the FAFSA. The people who benefit most from using insurance for college savings are people who sell insurance, not parents who are trying to pay for college. There are numerous reasons for this. Two simple ones are:

1. Although the FAFSA doesn’t require insurance to be reported as an asset, the CSS Profile does.

2. Insurance policies have a built-in cost structure of commissions as well as mortality and expense charges. These increase the cost of the policy and function like an expense ratio in a mutual fund: you don’t see it, but it reduces your return. Mortality and expense charges typically run around 1.5% annually; commissions account for 15-20% of premiums over the lifetime of a policy. Picking up that much cost for the purpose of avoiding listing a 529 as an asset just doesn’t pencil out. Least of all when the insurance huckster tells you to cash out your 529 to fund the insurance policy, which results in taxes and penalties for a non-qualified distribution. 

Comparing Qualified vs. Taxable: Savings

I’m sure you can appreciate the benefits of tax-free growth. Here’s an example of a family who contributed $10,000 when their student was born, then $1,000 per year through high school. The 529 or other tax-deferred account would be worth around $60,000 when the student finished high school, but taxes would reduce the taxable account’s value to about $50,000. Thanks to Vanguard’s tax-deferred savings calculator we can see the difference in account growth.

Comparing Qualified vs. Taxable: Spending

Then of course, the impact of taxable investments increases when you start spending the money during the college years. You’ve got less each year from the taxable account, and it will also impact your Expected Family Contribution (EFC*) on the Free Application for Federal Student Aid (FAFSA®). With taxable savings, you’ve also got some embedded gain that will increase your EFC If distributions were equal every year, that realized gain would increase the student’s EFC by almost $4,000 each year.

Similarly, 100% of a distribution from a Roth is added to income, so that would increase the EFC by almost $7,500 each FAFSA year.

• Spend down over four years

  • $15,000 annually from qualified

  • $12,500 from taxable

• $23,000 embedded gain in taxable

  • Increases income by almost $8,000 annually

  • Increases EFC by almost $4,000 each FAFSA year

• Roth distribution is 100% income on FAFSA

• Increases EFC by almost $7,500 each FAFSA year

* note the Student Aid Index (SAI) will replace the existing EFC starting from July 2023

The Best College Fund for Your Child

At risk of being glib, here’s my cheat sheet for who should use which account for college.

• UTMA: If you are absolutely positively never going to qualify for financial aid and want to transfer assets to child

• Both parents are doctors

• Taxable: If you aren’t encouraging child to attend college

• Coverdell ESA: If you’re committed to private K-12

• Roth IRA: If you’re a grandparent

• iBonds: If you’re very close to college

• 529: Everyone else

I admit I’m biased in favor of 529s. I like the tax-free growth, the age-based portfolios, the state tax benefits, the minimal restrictions. And while we as advisors often think that more choices, like a broader range of investment choices, are more beneficial to clients, many clients prefer simpler solutions.

But to my earlier point: some savings is better than no savings. That includes some savings in an account that maybe isn’t the best type. If you’re more comfortable with a brokerage account than with a 529, or you’d rather use your Roth IRA, do it. Something is better than nothing.

More Benefits of 529 Plans

529s have another advantage as well: Unlike distributions from a Roth IRA, which get added back to your income in the FAFSA formula, or from taxable accounts where the gains from selling investments to pay for college will flow through to the FAFSA as income, 529 distributions do not get added into the FAFSA and thus do not affect SAI (Student Aid Index).

Are you convinced that a 529 is where you want to save? Good. Now your next step is to pick a 529 plan, decide how much you can save, pick an investment option, and you’re on your way.

Choosing a 529

There are a lot of options because each state has at least one plan; financial services companies like Vanguard, Schwab, and Fidelity each offer their own; and a few private entities offer versions too

When it comes to choosing, the big question is do I use my state’s plan or a lower-cost plan? Here’s the good news: You can use any 529 to pay for any college that’s part of the federal financial aid system. That includes many international colleges and universities, plus community colleges, trade schools, and more. So choosing a plan doesn’t affect your ultimate college choice.

An easy way to get started is this: If your state offers a tax benefit for contributions, then that’s probably your best choice. If not, choose one of the low-cost options like Utah’s my529 (yes, you can sign up for this even if you can’t find Utah on a map) or Vanguard’s 529. If your financial advisor is encouraging you to sign up for a specific 529 such as an advisor-sold plan or the one at their investment custodian, ask them if they get a commission or management fee for your investment there. If their answer is yes, your answer is no. You should not pay management fees or commissions on your college savings. (Fees and expenses are the opposite of helpful to growing your investments.) Instead, choose either your state’s direct-sold plan or the Utah or Vanguard plan.
In addition, for residents of some states (like me in OR) who’s planning to use your 529 for k-12 expenses, you should choose an out-of-state plan for those dollars to avoid the state tax clawback.

Then there’s the question of prepaid plans like GET vs savings plans. Younger families are generally better off with savings plans because the growth should outpace inflation. Prepaid is great to add into the mix later. There are some private prepaid options like the Private College 529, but most of those have a limited network of colleges where you get the full inflation-adjusted tuition price, and you get much less if you go out of the network. And remember, prepaid plans are tuition only so you probably still want a savings plan.

Federal Revenue & Policy Changes that Impact 529s

The Tax Cuts and Jobs Act of 2017 (TCJA) and 529s

Some of the recent tax legislation has changed some of the rules for 529s:

• TCJA allows $10,000 per year for private K-12 tuition

• 21 states have conformed; OR does not

• OR residents using 529 for K-12 subject to state income tax on earnings and recapture of state tax deduction/credit (if OR 529)

• Qualified federal/Non-qualified state

SECURE Act of 2021 and 529s

The 2019 SECURE ACT permitted employees who are at least 50 years old to make catch-up contributions to their retirement accounts along with other college related benefits with the first allowing 529 distributions to pay back student loans and secondly may give grandparents a new way to take advantage of their savings.

The Secure Act expanded qualified expenses for students.

• SECURE Act allows 529 distributions for:

  • $10,000 of student loan debt (per beneficiary)

  • Tuition at trade/vocational schools

Options for an Overfunded 529

A lot of people worry about never spending their 529. 529s aren’t like FSAs where they’re use it or lose it, but you do give up the tax benefits if it doesn’t get used for education. Fortunately you have a lot of ways to use it for education even if the original beneficiary doesn’t use it.

You can also just take the money out. If it’s a non-qualified distribution– not used for education– then you pay taxes and a 10% penalty on the earnings. Note that’s paid by the person who receives the distribution, so you can distribute it out to your child probably at lower tax cost.

And if the 529 is overfunded due to scholarships, the 10% penalty on the distribution is waived.

• Change beneficiary to another family member

• Use for graduate school

• Save for next generation

• Non-qualified distribution

  • Tax on earnings, 10% penalty

  • Taxed to recipient

• If overfunded due to scholarships, only tax due on distribution

Summary - Saving for College Gives you Choices

If you save, you’re giving yourself and your child choices. If you know nothing else about saving for college, know that. When you save, your choices expand to the colleges you can afford through a combination of cash flow, savings, and loans – and that’s a larger pool of options. Not only that, but data shows that students whose families have saved for college – even very small amounts – enroll in and graduate from college at higher rates than those who don’t.

Table of Contents

1. Introduction

2. What is a 529 Plan?

3. Coverdell ESA

4. College Savings Bonds

5. Qualified Savings Options Compared

6. Roth IRA for College

7. Taxable: Parent-Owned or UTMA

8. Using Life insurance to Pay for College

9. Comparing Qualified vs Taxable: Savings

10. Comparing Qualified vs. Taxable: Spending

11. The Best College Fund for Your Child

12. More Benefits of 529 Plans

13. Choosing a 529

14. Federal Revenue & Policy Changes that Impact 529s

15. Options for an Overfunded 529

16. Summary - Saving for College Gives you Choices