Paying for your child's college education is probably one of the most rewarding investments you will ever make. To get the best bang for your buck, you will have to be strategic. To develop your college savings strategy, you should evaluate investment options, contribution limits, financial aid impact, and other key factors to determine which college savings option will make the most financial sense for your family.
Three common types of college savings accounts include the 529 Plan, UGMA/UTMA Accounts, and the Coverdell Education Savings Account (ESA). All of these accounts can serve as investment accounts to grow your child's college savings over time. Only the 529 Plan and ESA, however, will grow your investments tax-free. The catch is that all withdrawals from these types of accounts must be used for qualified education expenses. Qualified education expenses exclude costs such as transportation, medical expenses and certain types of room and board. This is where strategy comes into play.
UGMA/UTMA accounts allow the beneficiary to withdraw funds for whatever they like - room and board, transportation, medical expenses, spring break trips, or even business ventures. These accounts also have more investment options than the 529 plan. The downside to these accounts is that the income incurred on investments might be subject to the kiddie tax.
Another important factor to consider is the impact these savings accounts have on a child's financial aid package. The assets reported on the Free Application for Federal Student Aid (FAFSA) help the federal government determine a student's Expected Family Contribution (EFC) and distribute funds accordingly.
5.64% of assets owned by the parents are counted towards a student's EFC.
20% of assets owned by the student are counted towards a student's EFC.
Both the 529 Plan and the ESA are considered assets owned by the parents. UGMA/UTMA accounts are considered assets owned by the student. For purposes of financial aid, it makes more sense to have more funds in a 529 Plan or an ESA because assets owned by parents have a lower EFC.
The chart below summarizes the key differences between the three college savings accounts. Other factors to consider that are not detailed in the chart below include account fees, state tax implications and the option of creating a Roth IRA for your child. Although any type of college savings will significantly help your child get a healthy financial start to adulthood, you will want to weigh all of your options to make sure your investments put as much money as possible towards your family's future.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.