Importance of Savings

The sooner you start saving for college, the more funds you or your child will have available when the time comes. Even if you start putting money into a college savings account just a year or so before college, you or your child will still benefit. This is especially true when you combine your savings with other financial aid options, such as loans and grants.

College Savings Account Comparison

There are four primary college savings accounts you can explore. All of these can be opened for children; 529s and prepaid tuition are also available for adult students. Here is a comparison of each:

Features ESA 529 Custodial Prepaid Tuition
Earns federal tax-free interest Yes Yes No Maybe, in certain states
Earns state tax-free interest No Maybe, in certain states
No Maybe, in certain states
Offers tax-free withdrawals for educational expenses  Yes Yes No Yes
Offers tax-deductible contributions No Maybe, in certain states
No Maybe, in certain states
Limits contributions  Yes Yes No Maybe, in certain states
Permits transfer to another family member Yes Yes No Yes
Allowed for non-educational use Yes, with a penalty fee
Yes, with a penalty fee
Yes, without a penalty fee
No
Open to children Yes Yes Yes Yes
Open to adults No Yes No Yes

ESAs

Coverdell Education Savings Accounts (ESAs, previously called education IRAs) allow you to make contributions to a tax-advantaged investment account.

ESA Features:

Can only be opened for children age 18 and younger

Contributions are not tax-deductible and are capped at $2,000 per year

Earns interest tax-free

Funds are earmarked for educational expenses

Funds withdrawn for educational expenses aren’t taxed; funds withdrawn for non-educational purposes are subject to a 10 percent penalty and taxes

Investor decides how to invest the funds, as well as when and how to distribute them

Savings may increase or decrease in value depending on the investment’s performance

Account may be transferred to another member of the beneficiary’s family under age 30. Funds left in the account when the beneficiary reaches age 30 will incur taxes and a 10 percent penalty fee before being released to the beneficiary, not the ESA creator (or you can transfer the ESA to another member of the beneficiary’s family who is under age 30).

529 Plans

Most states operate 529 plans, which allow families to invest and grow savings tax-free and then later withdraw their savings, still tax-free, to use toward qualified K-12 and college expenses. These plans are similar to retirement funds in that they’re tax-advantaged, and you can choose from a selection of investment options, including mutual funds, stocks or fund portfolios. These plans get their name from Section 529 of the IRS code that created them.

529 Plan Features:

Accounts can be set up for investor or another beneficiary and can be transferred to another member of the beneficiary’s family

Earns federal interest tax-free. Some states also offer tax incentives.

Contributions are tax-deductible in certain states

Funds are earmarked for educational expenses

Funds withdrawn for educational expenses aren’t taxed; funds withdrawn for non-educational purposes are subject to a 10 percent penalty and taxes

Investor chooses from a selection of investment options, as well as when and how to distribute the funds

Savings may increase or decrease in value depending on your investment’s performance

Investments don’t have to be in the state you live in, nor do you have to apply the funds toward a college in your state. For example, you can live in California and invest in a 529 plan in Vermont and attend college in Texas.

Annual contribution level up to $70,000 (or $140,000 per couple) to a beneficiary

Private College 529 plans available for select private colleges

Custodial Accounts

Annual gifts up to $14,000 (or $28,000 per couple) for each beneficiary aren’t subject to the federal gift tax per the Uniform Gifts to Minors Act

Funds can be used for non-educational expenses without incurring a penalty

May only be opened for children age 18 and younger

Contributions aren’t tax-deductible

Account can’t be revoked or transferred to another beneficiary

Annual income taxes must be paid on account earnings as well as on the withdrawal

Funds in the account become the full property of the child when he or she reaches a set age determined by state law and don’t have to go toward educational expenses

Prepaid Tuition Plans

Sometimes called guaranteed savings plans, these plans enable families to pre-purchase all or part of the costs of tuition based on today’s rates at an in-state public college. When a beneficiary attends an eligible state college (or sometimes a private or out-of-state college), the program uses the funds to pay all or part of the tuition, regardless of whether tuition has increased over the years. The state absorbs the tuition increases. Be aware that some states may cap tuition contributions or end prepaid tuition plans altogether.

Prepaid Tuition Plan Features:

Accounts can be set up for investor or another beneficiary

Locks in today’s tuition prices

Some states offer a full or partial tax deduction for contributions to the state’s plan

Plan can be transferred to another member of the beneficiary’s family

Funds typically earn interest

Funds used for educational expenses aren’t taxed

Funds invested in a state-run prepaid plan can only be used at full value to pay for tuition and fees at in-state public colleges (you can use the funds for an out-of-state school, but not at full credit)

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