There is a theory in modern psychology that claims the abundance of choice in our lives leads to exhaustion. I mean, Amazon sells over 1,000 types of toilet brushes. Obviously this theory has led to much debate, but when we look at the option to help parents save for college, we can see these psychologists may have a point.
The number of savings vehicles and investment options out there can be overwhelming to even an experienced investor. Let’s look at six popular college savings vehicles and go through the good, bad and ugly of each. This should help remove some ‘choice anxiety’.
Savings Accounts
A deposit account held at a bank or other financial institution that provides principal security and a modest interest rate.
The Good
Savings accounts are great for conservative investors who don’t want to take on any risk. These principal-protected, liquid investments have a low financial aid impact. They also provide a small amount of interest.
The Bad
Interest rates in savings accounts have plummeted. In 1996, you were looking at an average interest rate around 2.1%. In 2010, that dropped all the way to 0.5%. Now, average rates are even lower.
The Ugly
With the cost of tuition currently increasing around 5-6% of year, a savings account will not come close with keeping up with college costs.
Coverdell ESAs
A tax-advantaged savings account designed for the payment of educational expenses.
The Good
Contributions are invested in securities that have the opportunity to keep up with or exceed the rising cost of college. All withdrawals are tax-free when used for qualifying education expenses. Money in the account can be used for K-12 costs, not just college.
The Bad
Gains in the account removed for non-educational costs (“non-qualified distributions”) will be subject to income tax as well as a 10% penalty.
The Ugly
Single filers with incomes between $95,000-$110,000 and joint filers with incomes between $190,000-$220,000 are phased-out from using these. There is a $2,000 maximum in contributions from all sources per year per beneficiary. Contributions must cease when the beneficiary turns 18, and he/she must use the account by the time they turn 30.
529 Plans
A state-sponsored, tax-advantaged savings plan designed to encourage savings for future college costs.
The Good
34 states and the District of Columbia currently offer some sort of tax incentive for contributions to 529 Plans. Nearly all plans offer at least one age-based investment. These portfolios automatically reallocate themselves to more conservative investments as the beneficiary approach college (much like target date funds in a 401K).
Contributions are invested in securities that have the opportunity to keep up with or exceed the rising cost of college. All withdrawals are tax-free when used for qualifying education expenses.
There are no income-phase outs meaning they are open for use by anyone. There are generous contribution limits with account balance maximums usually in excess of $300,000. Professional money managers chosen by the state, bring a level of sophistication out of reach for many investors.
The Bad
Gains in the account used for costs other than qualified higher education expenses will be subject to income tax as well as a 10% penalty. Money cannot be used for K-12 expenses.
The Ugly
Current law dictates you may only change 529 Plans once every 12 months. Additionally, you can only change your investment allocation once a calendar year.
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Roth IRAs
An individual retirement account that allows a person to set aside after-tax income. Withdrawals taken after the age 59 ½ are tax-free.
The Good
Money can be used for higher education expenses before the age of 59 ½ without incurring a 10% penalty. The account also serves as a retirement account. Investors can pick their own mix of investments. Accounts are not counted as assets for financial aid purposes.
The Bad
Funds used to cover college costs will count as financial aid income, which hurts aid eligibility the following year. There’s a maximum yearly investment of $5,500 ($6,500 if you’re over 65).
The Ugly
You pay income tax on gains if money is withdrawn for college before the account owner is 59 ½.
UGMA/UTMAs
A custodial account in which you can transfer assets to a minor under the Uniform Gifts to Minors Act (UGMA) and/or the Uniform Transfers to Minors Act (UTMA). These allow minors to own securities.
The Good
Shift accounts from a higher tax bracket to the child’s lower tax bracket. There are no contributions limits or income phase-outs. Money in the account can be used on anything (not just education).
The Bad
Gains in the account are taxable. Shifting ownership to the child means that the account has a harsh 20% assessment for financial aid purposes.
The Ugly
The beneficiary of the account gets control of the funds when they turn 18 allowing them to spend it on anything they please. This is why these accounts are sometimes called “Ferrari funds”.
Mutual Funds
An investment program funded by shareholders that trades in diversified holdings and is professionally managed.
The Good
Professionally managed mutual funds offer up a much wider range of investment options compared to other vehicles. Money can be used on anything, not just college.
The Bad
Income from these investments must be reported on your form 1040, which could drastically hurt financial aid eligibility.
The Ugly
Gains in the account are taxed at the owner’s capital gains rate.