Best Education Savings Plan for Children: 529 Plans Compared

Let’s just be honest- college expenses and private schools are shockingly expensive in the United States. Unfortunately, education costs continue to rise at about 2% per year. There are several routes when it comes to paying for college, often a combination of the following options are used:   

If you plan to save for your children’s education costs, there are multiple accounts to choose from. Let’s remove the guesswork and break down the best education savings plans for children. 

Best Education Savings Plans for Children 

Technically you can save for education in any type of savings or investment account. However, there are preferred tax benefits if you use the following accounts: 

You can open any or all of these accounts.

529 College Savings Plans

If your goal is to save all or most of the money required for your child’s education, there is no substitute for a 529 plan. 529 plans have no income restrictions or age requirements while permitting sizable contributions. Remember, you keep your annual contributions under the gift tax limit ($17,000 for 2023), or excess amounts will incur an additional estate tax. 

In a 529 plan, the ‘owner’ of the plan sets up and contributes the funds. The beneficiary is the child or individual who can use the funds in the future. 

Federal Income Tax Benefits

Contributions are made with post-tax dollars. The savings will grow tax-free, and the money can be withdrawn tax-free if used to pay for qualified educational expenses. 529s work much like Roth IRAs– if you meet the withdrawal requirements, you’ll never pay taxes on the money or earnings.

State Income Tax Benefits

Although 529 contributions are not deductible from federal income taxes, most states offer tax advantages, in the form of tax deductions or credits. Benefits vary and should be reviewed on a state-by-state basis here. 

An owner can open a 529 plan in any state they wish, but you can only receive the state tax deduction in the state where you file your tax return. If you file multiple state returns, you can choose the state with the most significant 529 deduction or credit. However, you can only take the deduction in one state, even if you set up multiple plans.

Qualified educational expenses

In order to withdraw 529 funds tax and penalty free, funds have to be used for qualified educational expenses. These expenses include the following:

Other qualifying expenses include:

Impact on Financial Aid

If you are applying for federal student aid, you should be aware that assets in a 529 plan will be included in the federal government’s determination of your financial aid eligibility. But wait- before you get nervous, let’s uncover how this actually works.

Three factors determine whether 529 funds are counted on the Free Application for Federal Student Aid (FAFSA) for accounts owned by students or parents.

• Simple Needs: If the parent’s combined income is less than $50,000, all assets are disregarded.
• Asset Protection Allowance: The government ignores a portion of the parent’s assets when determining how much a student qualifies for. Exact allowances are computed annually by the government and are based on the parent’s age, but currently disallows around $7,000 in assets.
• 5.64% on Additional Assets: Assets held in 529 plans will diminish your federal aid calculated ‘need’ by 5.64%. 

Based on the methodology, for every additional $10,000 in your 529 plan, you will lose out on $564 dollars of federal aid. If you contribute early and invest wisely, your tax free gains will easily overcompensate you for this amount of lost aid.

529: Contribution Limits

Remember, contributions are made to the account with after-tax dollars. The IRS views this money as a gift, so the donor must remain under the annual gift tax limits to avoid triggering additional estate taxes. 

The annual limit is $17,000 for 2023, up from $16,000 in 2022. Contributions must be made within the calendar year to be deductible (state level) for the given tax year.

The annual limit is a gift per individual, so a couple can contribute $17,000 each to the same child for a yearly total of $34,000. In addition, 529 plans may only have one owner and one beneficiary (there is no such thing as a joint 529 plan), so each adult would have to open a separate 529 plan to make the maximum contribution possible.

Super Funding

If you are looking to jump-start a 529 plan with an enormous contribution, you are allowed to contribute five years worth of giving ahead of time. This means a parent could technically contribute $85,000 or, as a couple, contribute $170,000. This will, of course, consume this year’s and the next four years’ worth of contributions but can start the tax-deferred growth sooner. 

If you really want to go big, you can technically make a contribution on Dec 31, and then superfund the next five years on Jan 1 of the following year. Contributions are made in the calendar year, so this strategy would allow you to make six years of contributions within two days.

529: What If You Need The Funds For Something Else?

As the account owner, you can always withdraw your contributions for any reason. Your contribution will not be taxed or penalized; however, any earnings portion of the money you withdraw (for a non-qualified education expense) will incur ordinary income tax and a 10% penalty.

529: What If You Contribute Too Much?

Perhaps the beneficiary chooses not to go to college or receives significant scholarships. In these instances, you have several options. 

Your first option is to keep the money in the account and continue to let it grow with tax-deferred status. This option makes sense if you believe the child may still use the funds for qualified expenses in the future. Accredited technical and vocational schools, as well as graduate schools, are acceptable uses for qualified distributions.

Alternatively, you could change the beneficiary at any time. You will not incur any tax consequences if you change the beneficiary to a qualified family member. The allowed family members list is quite inclusive and extends to in-laws, step-parents, aunts/uncles, cousins, and of course, any immediate family. Additionally, you can always name yourself as the new beneficiary. 

Many people find that they can use the funds for qualified expenses later during retirement. Degree or certificate programs are not required. Possible qualified uses for adult learners include- community college or university courses, study abroad language courses, and any related fees, books, supplies, and equipment (if the school is accredited).

If you don’t use the funds yourself, you can always change the beneficiary in the future to a grandchild.

Your final option is to withdraw the money and pay the taxes and a 10% penalty (only on the earnings portion). If the beneficiary does not use the funds because they received a scholarship, assistance from an employer program, or joined a U.S. Military Academy, the 10% penalty is waived.

Coverdell Education Savings Account

Coverdell Education Savings Accounts (ESAs) provide most of the same benefits as 529 plans. However, they have more rules, restrictions, and lower contribution limits.

There are no state tax deductions for Coverdell ESAs (as for 529 plans). However, federal taxes, tax-deferred growth, and federal financial aid calculations are all similar to 529 benefits. The following differences vs. 529 plans are explained below.

Pros vs. 529:

• Investment options: ESAs do have more flexibility in investment options than 529 plans which generally have a few index funds or mutual funds. Meanwhile, ESAs investments can be fully directed by the owner into specific stocks and bonds.
• Secondary school expenses: ESAs allow for both tuition and expenses related to secondary school to qualify for exempt withdrawals. By comparison, 529 plans only allow for qualified tuition (but not expenses) for secondary school use.

Cons vs. 529:

• Maximum contribution limit: The maximum contribution is $2,000 per year. 
• Income Limits: To qualify for any ESA contribution, a family must make less than $220,000, or $110,000 for single filers. To be eligible for the entire contribution, you must make less than $190,000 ($95,000 for singles), and the contribution phases out between these income levels.
• Beneficiary age: ESA contributions can only be given to minors under the age of 18. A 529 can be opened anytime for a beneficiary of any age. (You can open a 529 to pay for your own graduate school).
• Time limit for use: ESAs must be liquidated by the time the beneficiary is 30 years old. At that age, all the money needs to be removed, and taxes and penalties paid on any unqualified withdrawals. 529 plans have no time limits for use.

Coverdell ESAs are becoming less popular as some major brokerages such as Vanguard) are no longer opening new accounts. If you have an ESA, you can roll it into a 529 plan (but not visa-versa). I consider the minor benefits of the ESA plans to be negligible and irrelevant for most people’s needs.

If you are under the income limits for Coverdell ESAs, you can contribute to these plans in addition to a 529 plan.

UGMA and UTMA Accounts

Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) are custodial non-tax-advantaged accounts that an adult can fund on behalf of a minor. The two versions offer similar benefits but were created under various legislations (hence the different names). 

UTMA accounts are only offered in some states and transfer assets to the beneficiary at age 25, while UGMA accounts change custodianship at age 18 or 21 (depending on the state).

UGMA/UTMA accounts are not specifically education plans, but they qualify for a small tax deduction which can be supplemental savings for most parents. 

The uniform minors account allows $2,200 to be tax deductible for the donor. The first $1,100 is nontaxable to the minor. Meanwhile, the second $1,100 is taxable but at the minor’s tax rate (which is likely at a minimal tax rate). Any additional contributions will be taxed at the adult’s tax rate. Although there is no limit to contributing more, the tax benefits only apply to the first $2,200.

Important Consdierations For UGMA/UTMA accounts:

Less Access To Funds

Unlike 529 and Coverdell ESA plans, the owner does not control the funds once they are given to a uniform-minors account. The assets become the property of the minor and can only be used for their benefit.

Higher Impact on Federal Financial Aid

As UGMA/UTMA assets belong to the minor, they are treated differently than 529 or ESA plans regarding federal aid. 

Federal aid will be reduced by 20% of the account’s value (vs. only 5.64% for the education savings plans). Therefore, If you plan to apply for financial aid, you must consider your marginal tax bracket. Only set up a UGMA/UTMA account if your tax rate (and therefore deduction) is higher than 20%, or the deduction won’t be worth the lost financial aid.

Conclusion

The 529 plan is clearly the king of children’s education savings plans and is the best tax-advantaged savings account. 

If you qualify for a Coverdell ESA plan and wish to contribute more than the 529 limits allow, then the contribution to the ESA is a fine supplemental option, but it should not replace the 529 plan. However, if you do not use the funds in the Coverdell account, be sure to roll the plan into a 529 before the beneficiary turns age 30 to avoid taxes and penalties.

I recommend setting up a UGMA/UTMA in addition to a 529 plan for the additional tax deduction. However, only do so if the impact on financial aid is below the savings from the deduction.

Most importantly, start saving early, so the money has time to take advantage of the tax-deferred growth that the education savings plans offer.

Have any questions or comments? Feel free to contact me.

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