Originally posted on https://burneywealth.com/blog/the-alphabet-soup-of-education-savings-vehicles/

A major component of financial planning is saving for higher education expenses. With many available options, it can be daunting to know where to start. The purpose of this blog is to help you better understand the unique differences of the various education savings vehicles.

According to Sallie Mae,  general savings accounts held at a bank are the most often used funding vehicle for college. While utilizing a savings account for education expenses may seem like the easiest option, your savings may not go far enough when comparing the interest earned at most banks relative to the inflation rate of college expenses. For example, if your savings account earns 1% and annual college expenses are growing at 4%, your savings are not keeping up with rising costs.

Many do not know that there are savings vehicles that offer better growth opportunities and potential tax advantages. These are 529 Plans, Coverdell Education Savings Accounts, UTMA/UGMA accounts, and Roth IRAs.

The 529 is a tax-advantaged savings plan sponsored by every state and the District of Columbia. There are two types of 529 plans, Prepaid Tuition Plans and College Savings Plans:

• The Prepaid Tuition Plan allows you to “lock in” current tuition costs in a specific state to avoid the risk of cost inflation. The disadvantages with these plans is that they typically only cover tuition and fees for in-state public schools and if your child does not attend a public school in the state sponsoring the plan, your savings may not be enough. For example, if your child decides to attend a private or out-of-state school, the prepaid plan will generally only pay the average cost of in-state public college tuition.
• The College Savings Plan allows you to make contributions to an investment account that will grow tax-free so long as distributions are used for qualified education expenses (such as tuition and room/board). This benefit of a college savings plan is that it offers you more flexibility if the beneficiary of the account does not know where they would like to attend school (there are no state-related restrictions). The Tax Cuts and Jobs Act of 2017 made qualified expenses for K-12 private education eligible for tax-free withdrawals from these plans as well (up to $10,000/year). Many states also offer tax breaks and credits to residents.

A second education savings account is the Coverdell Education Savings Account (ESAs). These accounts are like 529 plans in that they also grow tax-deferred and withdrawals can be made tax-free for qualified education expenses. However, you are limited to a maximum annual contribution of $2,000 and if your adjusted gross income is more than $110,000 annually ($220,000 annually for those filing married filing jointly), you are unable to contribute.

Other options for education savings include UTMA/UGMA accounts. With an UTMA/UGMA account, assets are placed in the beneficiary’s name with you serving as custodian until they reach the age of majority in your state. Assets are subject to capital gains taxes and once the beneficiary reaches the age of majority, the assets transfer to their sole ownership to be used as the beneficiary wishes. This means that the assets you have saved may not be used exclusively or at all for higher education expenses.

Roth IRAs are also an option although as wealth managers, we would prefer those assets remain intact for retirement planning purposes. Since contributions to Roth IRAs are after-tax, withdrawals are made tax-free if you are older than 59 ½ which is a great benefit for retirement income and an inheritance to your heirs. However, the assets in a Roth IRA can be used for qualified education expenses without incurring the 10% penalty prior to reaching age 59 1/2, but the withdrawals may count as income when you file to FAFSA to determine financial aide eligibility.

The point in all of this is that there are several savings options for future college expenses. It is important to begin saving early and often. If you have questions or would like more information about your options, please give us a call.