Choices in College Savings Plans

The difference between major college savings plans: prepaid 529 plans, regular 529 plans, UTMA/UGMA accounts, Coverdell accounts, and Roth IRAs.

Is a specific type of college savings plan better for your own needs and style of investing? Let’s look at the differences in available investments and tax advantages to different plans. 

Prepaid 529 Plans

This might be the easiest investment decision of all — you don’t make any! But you’ll still need due diligence to ensure they’ll be solvent and able to fulfill their promises when your student needs them. There are currently 9 plans which remain open, but only during specific open enrollment periods. Only two (Massachusetts and a private-schools plan) are open to non-residents of a state. Each plan has highly individual rules: whether the amount contributed is tax deductible from state income taxes, what the purchase price might be, what are the age deadlines, etc. How is solvency protected? Do funds go into a trust, a bond-like investment, or do you depend on a state’s promise to provide the benefit in the future?

Since these accounts generally require you to purchase units (semester, year, etc.) or shares (1% of tuition, 50% of tuition) and only cover tuition, they won’t cover the entire cost of attendance. It’s impossible to determine return on investment, since we don’t know what the actual cost of a specific college will be in the future. You must use these at an in-state or member college to get full value, and the student must gain admission. Generally, the state-determined value can be used at other institutions, but may not cover other colleges’ tuition costs.

These programs do lock in the value of tuition against tuition hikes. They’re also a possibility for a one-time lump sum payment that you want to devote to ensuring that some costs will be covered: an inheritance, a prize, a bonus, or a relative’s gift. Finally, prepaid plans are useful when a parent or child might spend the money (withdraw from a 529 plan or delay college entry), as in a divorce, rather than using it for education.

529 Plans

These plans do require you to select an investment portfolio, but they’re designed for people who don’t have much investment knowledge or don’t want to sort through a plethora of choices. Even so, you're better served by being an educated investor. If you want to learn more about how investing works, you can start by sampling BetterInvesting's education, resources, and tools.

Each plan varies in what’s available. Usually offerings include an age-based portfolio that starts out heavily invested in stock mutual funds and moves toward mostly bond and money market funds nearer to college. These might subdivide into index-fund portfolios (my preference) and actively managed funds. The main problem I see with age-based funds is timing: what if the student delays college entry, or takes time off, or doesn’t need the money until graduate school? Then, the investments have become too conservative, too early. Investment Strategies in Saving for College provides a framework for building college savings for your children.

You might also choose a portfolio with a specific, steady balance. Sometimes these are based on how risk, and may contain somewhat more exotic offerings from a wider variety of fund companies. Keep an eye on each fund’s management fees.

You may get a state tax deduction if you are a resident, but you are free to invest in any state’s plan.
Most states add an administrative charge above the fund’s internal fees; some waive this for accounts over a specific balance. Also, you’re not going to be able to market time these accounts. Plans frequently permit only one or two investment changes in a given year.

You can use 529 plan funds at just about any accredited college or university in the U.S., and about 100 international ones. Determine this by checking whether the school has a code on the FAFSA.

Money withdrawn from these plans is tax-free if used for qualified expenses: tuition, fees, books, room and board if enrolled at least half-time, and study abroad programs. If the student receives scholarship aid, the equivalent amount of money can be withdrawn from the 529 plan, so even if your child is a genius and a sports superstar, don’t avoid saving. If indeed the plan is not used, it can be withdrawn, but earnings will be taxed and a 10% penalty will be assessed on the earnings (but not contributions). Plans can be passed down to immediate relatives: e.g., another sibling, the parent themselves, or nieces, nephews, or first cousins.

As long as the parent is the owner and the child the beneficiary (not the child as owner), it’s assessed in financial aid determinations as a parental asset (available at a maximum of 5.64% per year).

UTMA/UGMA Accounts

These were once quite popular as a way to have investments taxed at the child’s rate rather than the adults. Rules have changed dramatically and if a child still has one, roll it over into a 529 plan. The exception might be a child who has a very large UTMA or is earning money that is being deposited into the account. You need individual expert advice.

Coverdell Accounts

While these accounts have significant restrictions and limited contributions, you can freely invest in stocks within them. If you are eligible and begin contributing $2,000 each year from birth, you might have $10,000 or more for stocks while the student is still a child. This can be used as your high-stakes gamble—if it does well, you’ll have a boost in funds available. You need to be knowledgeable and comfortable with risk to reap a potential benefit.

Roth IRA Accounts

If you can’t predict the future, you may not want to overfund the 529 plan. Let’s say you were sure your child would attend Northwestern, and put away a quarter million for that, but Jack or Jill go to a community college instead, and live at home. You could be looking at a hefty tax bill to recoup that money. Instead, put up to the limit into a Roth account ($6,000; $7,000 if you’re over 50). You can withdraw your contributions tax free at any time for qualified educational expenses, although you will pay tax on the earnings. Or, if you don’t need it, it can sit tight for your own retirement. These accounts, like Coverdells, can be invested in individual stocks. While their value is not considered in financial aid determinations, withdrawals are considered income in the year withdrawn for financial aid determinations (but not taxes).

Caution: American Opportunity & Lifetime Learning

You cannot apply these to the same expenses as you paid from college tax-favored accounts. If your 529 plan covers all expenses that are eligible for these tax reductions, you won’t be able to apply them.