College isn’t cheap, but we all want our children to reach for the stars. Specialized accounts, like 529 Plans, UGMA accounts, or ESAs, are great options to help you set aside money for your child’s education expenses.
These specialized accounts, all a bit different in their own ways, offer certain tax benefits, allowing your savings to grow and be used more efficiently. Depending on what you want out of the account, certain options may be better suited for you than others. Let’s take a look at the top three most popular account types and what you need to know to decide which is right for you.
529 College Savings Plan
A 529 College Savings Plan is among one of the most popular account types for parents saving for their child’s education. Typically state-sponsored, the contributions you make to this investment account grow tax-deferred, meaning you typically won’t have to pay federal taxes on any investment gains in the account.
Benefits of a 529 College Savings Plan
- Tax advantages – Some states offer tax deductions or credits for contributions made to 529 Plans, making it a win for you during tax time.
- Flexibility – Though the funds are only exempt from taxes when used on education expenses, a wide range of expenses are covered and can be used at a range of institutions—from universities to vocational schools.
- Transferable beneficiaries – If your child finishes school and doesn’t use all of the money you’ve set aside, you can designate a different beneficiary within your family to use the leftover money.
Drawbacks of a 529 College Savings Plan
- Non-qualified withdrawals – Funds are subject to income tax and a penalty if they are used for non-qualified expenses. While funds can be used on other expenses, it’s not the best type of account to hold money for non-education-related spending.
- Financial aid eligibility – 529 Plans are considered a parental asset when applying for financial aid. While your account likely won’t impact financial eligibility too much, it is a factor to consider.
- Limited investment options – A more sophisticated investor might find that a 529 Plan offers limited investment options. However, many people find the simplicity of investment options to be quite helpful if they aren’t overly familiar with investing.
Uniform Gifts to Minors Act (UGMA) accounts are custodial accounts intended to help manage assets for a minor. UGMA accounts allow parents to transfer certain assets to a minor without the need for a formal trust.
Unlike 529 Plans and ESAs, UGMA accounts have no specific restrictions on how the funds must be used, making it a top choice among parents who want to set money aside for their children but don’t want to reserve it exclusively for education expenses.
Benefits of a UGMA Account
- Lower tax rate – UGMA accounts don’t grow tax-free like a 529 Plan, but income is usually taxed at your kid’s lower rate.
- Flexibility – Compared to other accounts, UGMA accounts are far less restrictive on how funds can be used. Sure, it can be used for education expenses, but it can go much further than that.
Drawbacks of a UGMA Account
- Taxing thresholds – Be wary of income thresholds. You might trigger the “kiddie tax,” leading to higher tax rates.
- Lack of control – When your child becomes of age, they take full control of the account and can use the funds for any purpose.
An ESA, or Education Savings Account, is another popular type of investment account used to save for education expenses. Much like a 529 Plan, an ESA must be used for education expenses—but, this account can cover primary and secondary education expenses as well.
Benefits of an ESA
- Tax advantages – Similar to 529 Plans, ESAs grow tax-deferred and funds can be used tax-free when used on qualified education expenses.
- Flexibility – In comparison to 529 Plans, ESAs offer a bit more flexibility because the funds can be used for primary and secondary expenses—not just higher education expenses.
- Investment options – ESAs offer account owners a bit more flexibility in terms of how their funds are invested, allowing you to choose different investment options and risk tolerance.
Drawbacks of an ESA
- Lower contribution limits – Compared to 529 Plans, ESAs have a bit lower contribution limits, meaning you may not be able to save as much as you could with the other account.
- Income limits – Income restrictions on ESAs might limit the amount you can contribute to the account.
- Age limits – You can only contribute to the account until your child reaches the age of 18, limiting your contribution window.
Each type of account offers its own strengths. A 529 Plan might suit education-centric dreams while UGMA accounts give you the liberty to paint outside of the lines a little bit. When choosing the right account for you, focus on your goals and how you intend for your children to use the funds. No matter which account you choose, know that you will be giving your child a huge leg up financially as they progress through their educational journey.