Understanding College Savings Plans

Saving for a child’s future college tuition can seem like an impossible mountain for parents to climb, especially with the costs of college rising across the country. Is an education-focused plan the way to go, or is the flexibility of a retirement account a safer bet? All savings plans come with their own pros and cons, but we’ll help you find the right plan for your family.

Picking a Savings Vehicle

Picking the right savings vehicle can mean a difference of thousands of dollars when it comes time to pay for your child’s tuition. If you’re setting up a savings account strictly with the intention of paying for your children’s future college expenses, the different options generally shake out in this order:

529 Plans and Coverdell (ESA) Accounts

529 plans and Coverdell Education Savings Accounts are at the forefront of college savings plans. They are both designed specifically for the purposes of education, so any withdrawals made for qualified education expenses are penalty and tax-free – which is their key benefit as a college savings vehicle. 529 plans often come with state tax benefits and allow for greater yearly contributions, while Coverdell accounts can also be used to pay for K-12 educational expenses.

While these college savings accounts do need to be reported on the FAFSA®, their impact on a student’s EFC score is typically minimal. The primary downside of 529 plans and Coverdell accounts is that there is a 10% penalty levied on any money withdrawn for any purpose other than a qualified education expense.

Roth and Traditional IRAs

An IRA is an Individual Retirement Account, which means that the funds in the account can be used for purposes other than education. Like a retirement account, neither is reported on the FAFSA®, leading to a better EFC score for the student.

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There is no early withdrawal penalty for any money used for qualified education expenses, but there is a limit on how much you can withdrawal without being taxed. With a Roth IRA, any income withdrawn beyond the owner’s original contribution will be taxed. Income withdrawn from a Traditional IRA beyond the amount of the deductible contribution will be taxed.

UGMA and UTMA Accounts

Another way to transfer money to your children or grandchildren for college is through the Uniform Gift to Minors Act and the Uniform Transfer to Minors Act. These accounts allow minors to own significant assets such as property, stocks, and bonds without an established trust fund.

For college savings purposes, UGMA and UTMA accounts carry some downsides. First, they are reported as a student asset on the FAFSA®, leading to higher EFC scores than parent-owned 529 and Coverdell accounts of the same value. Growth on these accounts also incurs income tax, and once the minor reaches the age of majority (usually 21 or 25), they are free to use those assets for any expenses or purposes they choose, not just education.

401k Plan

While a 401k plan has many positives as a retirement plan and is not reported on the FAFSA®, it offers little benefit for the purposes of paying for college expenses. Any income withdrawn before the owner turns 59 ½ will be subject to both penalty and tax.

Tip: Create distance between students and college savings plans

When coming up with a plan to pay for your children’s future college expenses, it’s important to remember how the FAFSA® calculates a dependent student’s EFC score.

Twenty percent of student-owned assets are factored into the EFC score, while the formula only counts 5.64% of parent-owned assets. Even though dependent student-owned 529 plans and Coverdell accounts are considered parent assets on the FAFSA®, families can still help themselves when Grandparents are involved.

Grandparent-owned assets are not included on the FAFSA® and therefore do not show up in the student’s EFC score. Those accounts will not show up on a student’s FAFSA® until two years after the student withdrawals money from those accounts, which is when those funds will need to be reported as student income. If a student can wait until their junior or senior year of college to withdraw money from those accounts, Grandparent-owned 529 plans and Coverdell accounts will not factor into the student’s financial aid at all.

Research Prepaid Tuition Plans

In addition to traditional state-offered 529 plans, some states also offer more direct prepaid tuition plans. In the face of ever-rising tuition bills, prepaid tuition plans allow individuals and families to prepay future college tuition fees at today’s prices. These tuition credits are returned or transferred should a child decide not to attend college or enroll in an out of state university.

Private and independent schools also offer their own version of the prepaid tuition plan, called the Private College 529 Plan. Nearly 300 private and independent universities are now participating in the Private College 529 Plan.