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Guide to College Savings Accounts and the Different Types

College Savings Accounts: Different Types
Caroline Banton
Caroline BantonUpdated February 23, 2023
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College savings accounts are designed to help parents set aside money for a child’s future college tuition and expenses. Often, these accounts offer tax benefits as well as investment options so the money you put in can grow over time. The most common types of college savings accounts are 529 plans and Coverdell  accounts. However, there are other savings and investment options that can work well for college costs, including custodial accounts, mutual funds, and Roth IRAs. Read on to learn how different college savings plans work, how to choose the right plan for your needs, and how to get started.

What Is a College Savings Account?

A college savings account is a way to save for the cost of a child’s college education. In many cases, the money you deposit into a college savings account is tax-deferred. This means that any money the account earns in interest, dividends, or capital gains, aren’t taxed while the money is in the account. And, if you use the money for qualified education expenses (such as tuition, room and board, supplies, and books) you can withdraw the funds tax-free. Recommended: Guide to Student Savings Accounts

6 Types of College Savings Accounts

The type of college plan that is right for you will depend on multiple factors, including your income, the current age of your child, and how much you want to save. Here’s a look at some popular college saving options.

529 Plans

These savings plans are usually sponsored by state governments and many states will let you deduct your contributions from your state income tax. Your money will grow tax-free and, if you use the funds for qualified education expenses (which include college and K-12 private school expenses), you’ll never pay tax on the growth. You can put money into your own state's 529 or any other state's plan, and there is no annual limit on the amount you may deposit. (There are limits on the total amount you can contribute to a 529, but these are generally high.)

Coverdell Education Savings Accounts (ESA)

You can use a Coverdell Education Savings Account (ESA), which is a U.S. government-sponsored plan, to fund educational expenses for grades K-12 and college. The maximum amount you can contribute to an ESA is $2,000 per year, and you must use the funds by the time the beneficiary reaches age 30. Like a 529, earnings accumulate tax-free and distributions are free of income taxes as long as the funds are used for educational purposes. However, Coverdell ESAs are only available for families below a certain income limit ($110,000 for single filers; $220,000 for married couples filing jointly). 

UTMA or Custodial Accounts

A custodial account — also known as a UTMA (for the Uniform Transfers to Minors Act) — is a brokerage account that an adult manages for their child until they reach legal age (18, 21, or 25 depending on your state). At that point, the child gets ownership of the account. Custodial accounts can hold cash, stocks, and mutual funds, and there is no limit to how much money you can put into the account. Unlike some other college savings accounts, custodial accounts don’t offer tax-free growth. However, you can use the account to cover any kind of expense, including costs that college plans don't cover. Just keep in mind that the child will legally be able to use the money in the account in any way they choose (for college or for something else).

Traditional Savings Accounts

You can also use a regular savings account to save for college expenses. These accounts offer flexibility, since there are no limits on how much you can deposit into the amount each year, and you can use the funds for any type of college expense. However, most bank savings accounts earn relatively low interest rates, so the money will likely not grow as much as it could with other college saving options. In addition, there are no tax benefits — any interest earned is considered taxable income the year it is earned. Nevertheless, if your child is leaving for college soon, a high-yield savings account can help you put aside money while earning competitive interest.

Mutual Funds

Mutual funds are investment vehicles that pool money from many investors to buy a portfolio of stocks, bonds, or other securities. A professional money manager oversees the fund. An advantage of using a mutual fund for college saving is that the money can be used for anything, not just certain education expenses. Also, a mutual fund could potentially lead to better returns than other types of college savings accounts. On the downside, there are no tax benefits. Recommended: Saving vs Investing: Which Is Right For You? 

Roth IRA

While Roth IRAs are not specifically designed for college savings, you can use this retirement investment account to pay for a child’s education. Like other college savings vehicles, Roth IRA accounts are funded with after-tax dollars and grow tax-free. You can withdraw money from a Roth IRA for educational purposes without paying a penalty – though you’ll still have to pay income taxes on the earnings. If you withdraw the money after age 59 ½, however, you won’t pay any tax on those earnings. There are income and contribution limits with Roth IRAs, however, which you’ll want to understand and consider before opting to use this type of account for college saving.

What Is Generally Considered to Be the Best Type of Savings Account for College?

It depends on your situation but, for many people, a 529 plan can be a great choice for college saving. There are numerous plans to pick from, no income or annual contribution limits, and you get to enjoy tax-free growth when you withdraw the money.Recommended: Understanding Different Types of Bank Accounts 

How Does a 529 Plan Work?

Once you open a 529 plan, you make contributions with after-tax dollars on whatever schedule you choose. You might set up an automatic transfer of a certain amount from your checking account into your 529 each month to simplify the process. The funds in the account grow tax-free and, if you use the money to pay for qualified education expenses (which includes college tuition and expenses and up to $10,000 per year in K-12 tuition), you won’t ever need to pay tax on the growth. Some states offer additional state tax benefits.

Types of 529 Plans

There are actually two types of 529 plans: education savings plans and prepaid tuition plans. Here’s how they differ.

Education Savings Plans

An education savings plan is the most commonly used type of 529. This plan allows you to open a tax-advantaged investment account on behalf of your child. You can use the fund to pay for tuition, as well as room and board, and some other qualified expenses.   

Prepaid Tuition Plans

A 529 prepaid tuition program essentially allows you to pay for a future student’s college education at today’s prices. When you withdraw the money (or credits) to pay for college, it’s not taxable. However, prepaid tuition plans do not cover the cost of room and board, and only some states and colleges and universities participate in the program. Recommended: Using a 529 Plan vs a Savings Account for College

Factors to Consider Before Opting for 529 Plans

Before deciding that a 529 plan is the right savings option for your family, you’ll want to consider whether or not you plan to use the money primarily for qualified college expenses (like tuition, room and board, and supplies). The reason is that 529 plans will charge you taxes and a penalty fee if you withdraw the money for anything else (such as buying your child a car or covering bus/train/airfare to get to and from college). If you think you will need the money for a lot of unqualified education expenses, a custodial account or mutual fund might be a better fit.Recommended: 52-Week Savings Challenge Guide 

Benefits of 529 Plans

Here’s a look at some of the benefits of a 529:
  • Grows tax-free
  • Withdrawals are tax-free if used for qualified education expenses
  • No annual contribution limit
  • High total contribution limit (ranging from $235,000 to $550,000, depending on the state)
  • Considered a parent’s asset, which may be helpful when a student is applying for financial aid
  • Contributions up to $17,000 per year per parent will qualify for the annual gift tax exclusion.

Steps for Opening a 529 Plan

Here’s a simple step-by-step for opening a 529 plan.
  1. Research plans All states, along with many brokerage firms, offer 529 plans, so it can be worth shopping around. You might start by looking at your own state (some states will offer a tax deduction for 529 contributions, but not all), then expand your search to other 529 plans looking carefully at past performance and fees. 
  2. Open the account Typically, you can open a 529 plan online. To complete the application, you’ll need to choose a beneficiary (likely your child) and have their date of birth and Social Security number. You’ll also need to provide information about yourself.
  3. Choose your investments Once you pick a 529 plan, you may have a choice of investment options. Some plans offer both age-based target-date funds, as well as individual portfolios options. 
  4. Fund your 529 You can make your first deposit by transferring money from your checking or savings account. You may then choose to set up a recurring transfer of a certain amount per month so you won’t have to remember to contribute to your 529. Or, you may be able to have a portion of each paycheck direct deposited into the account.
Recommended: Guide to Opening a Savings Account Online 

How Scholarships Affect 529 Plans

Some parents hesitate to commit to a 529 plan because they are hoping their child will earn a scholarship. The good news is that, should your child get a scholarship (or decide not to go to college), you won’t lose the money you saved. You have two options: One is to transfer the money to another child’s 529. Another is to make a non-qualified withdrawal, which means you’ll have to pay income taxes (plus a 10% penalty) on the growth.

Tools for Planning College Funds

The website offers practical tools for planning college funds, such as a college savings calculator, financial aid calculator, state tax 529 calculator, and a 529 plan comparison tool.Recommenced: What Is Budgeting and How Can You Start? 

Age Groups Eligible for College Funds

The beneficiary of a 529 education savings plan can be any age as long as you use the funds for qualifying education expenses. Account holders can be of any age too as long as they are legal adults. Some states, however, have age restrictions for prepaid tuition 529 plans. To open a Coverdell ESA, the beneficiary must be under the age of 18 or be a special needs beneficiary. Also, the money must be used by the time the beneficiary reaches age 30 (unless they are a special needs beneficiary).

When to Establish College Funds

It’s never too late to start saving for college. Ideally, though, you’ll want to start soon after your child is born. This allows your monthly or annual contributions to grow over a long period of time. Thanks to the power of compound interest (when the interest you earn on your contributions also earns interest), you generally won’t need to set aside as much if you start saving when your child is young versus starting later.Recommended: Guide to Saving Money for Kids 

The Takeaway

As the cost of going to college continues to rise, choosing a savings plan is a pressing concern for many parents. There are numerous choices — including 529s, Coverdell ESAs, and regular savings accounts  — and each has benefits and drawbacks. Whichever option you choose, the key to success is to start and regularly add funds to the account.Whether you’re putting aside money for college or any other upcoming expenses, you’ll want to get the best possible return on your savings. With Lantern by SoF’s online banking marketplace, it’s quick and easy to compare high-yield savings accounts based on annual percentage yield (APY), fees, and balance minimums.Lantern can help you compare online savings accounts and find today’s best rate.

Frequently Asked Questions

What is the maximum amount I can put in a 529 plan?
How do I choose a 529 plan?
How much does a 529 plan cost?
What are the best college plans?
What is the ideal age to commence a college plan?
Photo credit: iStock/PeopleImages

About the Author

Caroline Banton

Caroline Banton

Caroline Banton is a finance and business writer whose work has appeared on sites such as The Huffington Post, Investopedia, The Motley Fool, LendingTree, MSN, and Time. With an MBA from Johns Hopkins University, Caroline has written for fintech companies, acted as a career coach, and ghost-written for prominent thought leaders in the financial industry.
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