6 College Savings Accounts and How They Work
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- College savings accounts allow families to store and save money for a child's education.
- Some of the best college savings accounts include the 529 plan and the Coverdell ESA.
- All college savings accounts maintain different eligibility requirements and restrictions.
Saving for college is rarely easy. Fortunately, college savings accounts can help students and families effectively save money for college and plan for their academic futures.
In most cases, parents or guardians open a college savings account to store money for their child's education. Other college savings accounts may be opened in the student's name or by the student.
Each account comes with different eligibility requirements and limitations. The Coverdell ESA, for example, maintains income limits, whereas the 529 plan does not. The 529 college savings plan is considered one of the best savings accounts for college students, but it's far from your only option.
Here, we go over the six types of college savings accounts, how they work, and their biggest pros and cons.
1. Coverdell ESA
Coverdell education savings accounts, or ESAs, are tax-advantaged investment accounts that help families pay for qualified education expenses. These college savings accounts offer lower fees and more investment options than 529 plans, making them an attractive option for soon-to-be college-goers.
Beneficiaries of Coverdell ESAs must be less than 18 years old when the account is set up.
- Can be used for primary, secondary, or postsecondary education.
- Offers tax-free withdrawals when funds are spent on qualified education expenses.
- Contributions must be used by the time the student is 30 to avoid penalties and taxes when withdrawing money.
- Income restrictions mean the ability to contribute to a Coverdell ESA is limited by the modified adjusted gross income set for a given tax year.
- Contributions are limited to $2,000 per child each year.
2. 529 Plan
A 529 plan is a tax-advantaged investment vehicle similar to a Roth IRA (see No. 6 below).
There are two types of 529 plans: the education savings plan (also called the college savings plan) and prepaid tuition plans. The former can be used for any and all education expenses, including books and room and board, whereas the latter can only be used to cover tuition and mandatory fees.
- Contributions can be used by the student or child at any time throughout their life.
- No income restrictions.
- Contributions can only be used for qualified education expenses.
- Noneducation expenses are taxed.
3. UTMA or UGMA
UTMA and UGMA accounts are custodial accounts that can be used to hold funds for minors until they come of age. Recipients receive control of their UTMA or UGMA accounts as soon as they reach the age of majority in their state, which is anywhere from 18-21.
- Funds can be used for more than just education expenses — if the student wanted to open a business with the money, for example, they could.
- Anyone can make contributions to the account in the form of stocks, bonds, mutual funds, and even intellectual property.
- Can greatly reduce the amount of need-based financial aid a student receives for college since all funds are in the student's name.
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4. Mutual Funds
Mutual funds are professionally managed investment portfolios that pool money from many investors to buy shares of stocks, bonds, and other securities. Some think mutual funds offer higher returns than 529 plans, making them popular choices for college savings accounts.
- Money can be used for anything, not just education expenses.
- No age requirements or restrictions.
- Could lead to higher returns than other college savings accounts.
- Mutual funds distribute capital gains, which is considered income and can affect the amount of need-based financial aid a student can receive.
- Funds may have a kiddie tax.
5. Qualified U.S. Savings Bond
A savings bond is a type of government-issued investment vehicle that offers a fixed interest rate over a set period of time. The returns from bonds are modest, but since they're backed by the federal government, they're generally considered safer than other investments.
- Bonds are guaranteed by the U.S. government, making them a relatively safe investment.
- Tax benefits may be available when redemption amounts are used to pay for education expenses.
- No age restrictions.
- The returns you'll receive from bonds are typically smaller than those from other investments.
- Education bonds can only be used for qualified education expenses — primarily tuition and fees — at postsecondary institutions eligible for federal student aid.
- Room and board is not considered a qualified education expense.
6. Roth IRA
Established in 1997, Roth IRAs are tax-advantaged retirement accounts that can also be used to save for college. These plans are less restrictive than other retirement accounts and are available at nearly all banks, investment companies, and brokerage firms in the U.S.
- Funded with after-tax dollars, so money grows tax-free.
- Funds can be used for your retirement or your child's education, giving you ample flexibility.
- Can withdraw money you've contributed tax-free as long as it's considered a qualified distribution.
- Money you withdraw from your Roth IRA each year to pay for your child's college education may be considered income on the FAFSA.
- Contribution limit is $6,000 per year for 2020-22 and $7,000 per year for those age 50 or older.
- Any earnings you withdraw before age 59 and a half are taxed.
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