Saving for your child’s college education is one of the most significant financial decisions you can make as a parent. With the rising costs of higher education, starting early and choosing the right savings vehicle can make a substantial difference in your child’s future. Fortunately, there are a number of college saving account options with special tax structures you can help your savings grow over time.
Ahead, we’ll walk you through some of the most popular types of college savings accounts, including 529 plans, Coverdell Education Savings Accounts (ESAs), custodial accounts (UGMA/UTMA), and high-yield savings accounts. We’ll explore how each option works, their pros and cons, and how they can fit into your overall savings strategy.
Key Points
• 529 plans offer tax-deferred growth and tax-free withdrawals for qualified education expenses, with potential state tax breaks.
• Coverdell ESAs provide tax advantages and flexible investment choices, but have a $2,000 annual limit and a withdrawal deadline.
• Custodial Accounts (UGMA/UTMA) allow a wide range of investments, but don’t offer tax advantages.
• High-yield savings accounts offer low-risk growth and easy access to funds, but lack tax advantages.
• Each account type has unique benefits and drawbacks, so parents should consider their specific financial goals and timeline.
529 Plan
A 529 plan is one of the most popular and effective ways to save for college. It is a tax-advantaged savings plan designed specifically to encourage saving for future education costs.
529 plans are sponsored by states and generally allow federally tax-deferred growth and tax-free withdrawals as long as you use the money to pay for qualified education expenses. You can use any state’s 529 plan, but some states offer incentives for residents to use their plans, such as state income tax benefits.
A 529 plan also has other uses: You can tap up to $10,000 a year from a 529 plan to pay for elementary, middle, and high school expenses. Plus, your child can use up to $10,000 in a 529 plan to pay off student loans without getting hit with penalties or tax consequences.
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Pros and Cons
A 529 plan offers a number of advantages, but there are also some downsides to consider.
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Pros:
• Contributions to a 529 plan grow on a tax-deferred basis.
• Qualified withdrawals for education expenses are tax-free.
• Some states offer tax breaks for 529 plan contributions.
• You can contribute to any state’s 529 plan, regardless of residency.
• Anyone can contribute.
• If your child doesn’t go to college, you can change the beneficiary.
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Cons:
• Taxes and penalties apply when you use 529 plan money for anything other than qualified education expenses.
• Annual contributions that exceed the annual gift tax exclusion limit can trigger the gift tax.
• There may be limited investment options, as well as fees.
• You won’t get a federal tax deduction for 529 plan contributions.
• State tax breaks are limited to state residents.
Coverdell Education Savings Account (ESA)
A Coverdell ESA is another tax-advantaged account designed for education savings. The money you invest in an ESA grows tax-deferred and withdrawals are free of federal taxes as long as you use the money for qualified education expenses. Tax-free withdrawals apply to elementary and secondary education expenses, as well as college expenses.
ESAs generally offer a wider selection of investment options compared to a typical 529, and don’t have the 529’s $10,000 tax-free withdrawal limit for qualified elementary or secondary school expenses.
But there is a hitch with this type of college savings account: The maximum amount you can contribute to a Coverdell ESA annually is $2,000 for joint filers with a modified gross income (MAGI) up to $190,000; the amount is gradually reduced for MAGI between $190,000 and $220,000. If your MAGI is above $220,000, you are ineligible to open an account.
Pros and Cons
Coverdell accounts offer some advantages over 529 plans, though they fall short in other areas. Here are the main benefits and drawbacks to consider.
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Pros:
• Coverdell accounts may offer a greater range of investment options compared to other college savings plans.
• Contributions grow tax-deferred.
• Qualified withdrawals for education expenses are federally tax-free.
• You can change the beneficiary to another qualified child if needed.
• You can save in a Coverdell account and a 529 plan for the same student.
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Cons:
• Your income must be below certain limits to contribute to a Coverdell ESA.
• Annual contribution limits are low.
• You can’t make new contributions after your child turns 18 unless they’re a special needs beneficiary.
• All money in the account must be withdrawn by your child’s 30th birthday unless they are a special needs beneficiary.
Custodial Account (UGMA/UTMA)
Custodial accounts created under the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) allow parents and others to hold assets in a child’s name until they reach the age of majority (18 to age 25, depending on the state). These accounts are not specifically designed for education savings, but they can be used for any expense that benefits the child, including education costs. Once your child reaches the age of majority in your state, the money in the account becomes theirs.
UGMA or UTMA accounts are generally the same, but the kind of assets you can contribute differ. With a UGMA, you can contribute cash; stocks, bonds, and other securities; and insurance policies. With a UTMA, you can contribute any kind of asset including real estate. State law determines whether you can open a UGMA or a UTMA to save for college on behalf of your child.
Custodial accounts don’t have the same tax advantages as 529 plans and Coverdell accounts.
Pros and Cons
Custodial accounts can help you set aside funds for a child’s future college education but it’s important to consider the pros and cons before opening one.
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Pros:
• You can generally contribute up to the annual gift tax exclusion limit for each child, each year without triggering a gift tax.
• Depending on where you open the account, you may have access to a wide range of investment options.
• Anyone can contribute, without income restrictions.
• There’s no tax or other penalty if your child uses the money for anything other than college.
• Investment earnings are generally taxed at the child’s tax rate, which is usually lower than a parent’s rate.
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Cons:
• You can’t change the beneficiary of a custodial account.
• Once your child reaches the age of majority in your state, they can control what happens to the money you saved for them.
• There are no tax benefits for contributions and earnings are taxable.
• Custodial accounts may impact your child’s financial aid eligibility.
• If investment income exceeds a certain limit, it may trigger the kiddie tax.
High-Yield Savings Account
A high-yield savings account (HYSA) is a type of savings account that offers higher interest rates than traditional savings accounts. For example, an HYSA can pay 9x the national average interest rate for savings accounts. While HYSAs don’t offer tax advantages like 529 Plans or ESAs, they provide a low-risk way to grow savings while maintaining easy access to funds.
You can open high-yield savings accounts at banks and credit unions. The specifics of these accounts, including rates, fees, and minimum balance requirements, vary from one financial institution to the next. Online banks and credit unions tend to offer higher rates and charge fewer fees compared to traditional banks.
Though the returns you can earn on an HYSA may be minimal compared to what you could earn by investing in the market over the long term, a HYSA can play a complementary role in your college savings plan. Should your child choose not to attend college, the money can be used for any purpose.
Pros and Cons
Is a high-yield savings account a good choice for college savings? Yes and no. Here’s what to know.
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Pros:
• Money kept in a high-yield savings account can be easily accessed at any time.
• Savings accounts are safe — they are typically insured up to up to $250,000 per account holder, per insured institution, per account type.
• You can use the money however you want.
• There are no requirements on when you must take money out of a savings account so your money can grow until you need to spend it.
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Cons:
• Money invested through a 529, ESA, or custodial account may earn a much higher rate of return than a high-yield savings account.
• You don’t get any tax benefits from a savings account and the interest earned is taxable.
• You may need to meet minimum balance requirements to avoid a monthly fee.
The Takeaway
When it comes to saving for college, there’s no one-size-fits-all solution. Each type of savings account comes with its own benefits and drawbacks, making it important to consider your financial goals, risk tolerance, and time horizon.
529 plans can be ideal for those looking for tax advantages, high contribution limits, and funds earmarked specifically for education. Coverdell ESAs, on the other hand, offer greater investment flexibility but come with income and contribution limits. You can also use a custodial account to save for college; these provide more spending flexibility but may negatively affect financial aid.
Whatever way you go, a high-yield savings account can play a key and complementary role in your college savings plan, especially if you choose a bank that offers an above-average interest rate and charges low or no fees.
Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.
FAQ
What is the difference between a 529 and a Coverdell?
A 529 plan and a Coverdell ESA both help save for education and both offer federally tax-deferred growth and tax-free withdrawals (if funds are used for qualified education expenses). However, they differ in key ways. A 529 plan has high contribution limits, no income restrictions, and may offer state tax benefits. A Coverdell ESA has a $2,000 annual contribution limit per child and income limits for contributors. An ESA also typically allows more investment options compared to a 529.
Is it better to put money in a 529 or savings account?
A 529 plan is usually better for long-term education savings due to its tax benefits. Earnings grow tax-free and withdrawals are tax-free if the money is used for qualified education expenses. Some states also offer tax deductions for contributions.
Savings accounts offer more flexibility, since there are no restriction on how you use the money. However, they don’t have tax advantages, and interest rates are typically low. If you’re saving specifically for education, a 529 plan often provides better growth and savings potential than a traditional savings account.
How is a Coverdell ESA different than a 529?
A Coverdell ESA allows up to $2,000 in annual contributions per child, with income limits for contributors. It offers more flexible investment choices and can cover a wider range of K-12 expenses, like tutoring and supplies.
A 529 plan has no income limits, higher contribution limits, and often state tax benefits, but investment options are usually more limited. Coverdell ESAs also have a withdrawal deadline at age 30, while 529 plans do not.
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