Personal Finance

Choosing a College Savings Vehicle

Where should families put the money they’re saving for college? A 529 college savings plan? A Coverdell education savings account (ESA)? A standard brokerage account in the parents’ names? Or maybe a custodial account for the student-to-be? Each option has pros and cons. Here’s a look at important factors that may influence the choice of a college savings vehicle.

Tax Treatment

Both Section 529 plans and ESAs offer federal income-tax advantages. Although contributions to either type of account are nondeductible, any investment earnings accumulate on a tax-deferred basis. Withdrawals for the beneficiary’s qualified education expenses are tax free, meaning the investment earnings escape income tax altogether. If money is withdrawn for other purposes, income taxes and a 10% penalty are imposed (on previously untaxed earnings).

How are 529 plans and ESAs different tax wise? For one, ESA contributions for a beneficiary are subject to a maximum annual dollar limit. In contrast, the federal tax law doesn’t restrict annual 529 plan contributions. And plan-imposed contribution limits tend to be quite generous.
Higher income taxpayers face further restrictions on the ESA contributions they can make. The allowable ESA contribution is phased out as modified adjusted gross income rises from $95,000 to $110,000 (or from $190,000 to $220,000 for married taxpayers filing jointly). If income exceeds the top of the range, no ESA contribution is permitted that year. There aren’t any income restrictions on 529 plan contributions.

The tax treatment of custodial accounts established under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) is different. Investment earnings are taxed annually to the child, generally at the parents’ higher income-tax rate because of the tax law’s “kiddie tax” rules. Choosing growth-oriented investments, such as stocks, that don’t regularly pay dividends or interest can help counter this unfavorable tax treatment.


A custodial account has another potential drawback: The child assumes control of the funds at age 21 or 18, depending on state law. This isn’t the case with a 529 college savings plan owned by the parents. Parents may change the beneficiary to another family member without adverse tax consequences or close the account (and pay applicable taxes and penalties). With an ESA, the beneficiary assumes control of the account at age 21 (or 18). To maintain tax advantages, all ESA assets must be distributed by age 30. Parents who don’t want to give up any degree of control over their assets may prefer to use a standard brokerage account to accumulate savings they’ve earmarked for college.

Investment Choice

Of all the alternatives discussed here, a 529 plan may offer the most limited investment options. 529 plans typically offer a menu of investment options and restrict the number of times investment changes may be made. Since investment options vary from plan to plan, potential investors should do their homework carefully before committing to a particular state’s 529 plan.

Financial Aid Impact

How college savings are held may affect a child’s ability to qualify for need-based financial aid. The federal financial aid formula considers both parental and student assets, but student assets count more heavily as resources available for college expenses. 529 plan accounts and ESAs held in either the parents’ or the student’s name are considered parental assets. UGMA/UTMA accounts are student assets.

Source: DST

Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

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