ESA vs 529 Plan: Types of College Savings Accounts

by Silicon Valley Blogger on 2011-03-310

I am a parent who used to be a lot more laid back about the long term goal of saving for college. But with college tuition and other related expenses increasing each year, it’s become tougher to play catch up to this savings goal. So with the cost of a college education rising every year, parents must plan for future college expenses unless they want their children to rely solely on student loans. According to a recent study, the average student who attends a four-year college will graduate with at least $19,237 in debt (according to I cannot think of a better reason to start saving now. Why not provide your kids with a fighting chance instead of allowing them to graduate with massive debt and many steps behind their peers in the working world? That said, you may wonder what kind of college savings plan would be the best fit for your needs. It’s a good thing that there are several options available for those wanting to save for college.

ESA vs 529 Plan: Various Types of College Savings Accounts

529 Savings Plans

I’ve talked quite a bit about the 529 College Savings Plan, which is the kind of account that I actually have. It’s the popular choice for college savings, given that it’s tax advantaged (like our retirement accounts). There are two types of 529 plans: a College Savings Plan and Prepaid Tuition Plan. The prepaid tuition plan allows you to purchase units or credits at a participating college, and you can lock in tuition rates at current prices. The cost of the plans are set, which you can then pay in lump sum or in installments. On the other hand, the College Savings Plan is a fund you can contribute to up to a particular limit (e.g. many are over $200,000). The savings plan is tied to the stock market and allows you to select among several investment options including mutual funds and money market funds, although a professional manager is responsible for managing your account. You can then pay your educational bills from this plan. Whichever 529 savings plan you choose, you do want to ensure that it does not limit or freeze your options or automatically change your investment amounts based on the age of the your child.

I have the College Advantage Ohio 529 Savings Plan as well as the Nevada 529 Plan that invests in Vanguard funds. But your case may be different. Your choice of college student savings account will depend on your own personal circumstances and how you are planning to manage your child’s educational needs. For instance, will you be seeking financial aid for your student? Do you know how much you can afford to save? Some of these questions may influence the direction you should take.

Coverdell ESA (Education Savings Account)

Another choice for college savings is the Coverdell ESA, also known as a Coverdell Education Savings Account. It allows you to invest $2,000 per year for each child that you have. While it sure has the feel of an IRA — well it used to be known as an Educational IRA — take note that the $2,000 invested is after tax money, but your earnings on that money grow tax-free. Therefore, if you begin investing when your child is born and keep on with your contributions until your child is 18, you will have a nice chunk of change when they turn 18 and are ready for college. If you select an ESA account that yields an annual average of 10%, you’ll have a large portion (if not all) of your child’s undergraduate education covered. This $2,000 compounded over 18 years will yield around $100,000 for your child’s college education. Let’s just say that being proactive is a lot better than having to figure out how to afford student loans! The Education Savings Account does have some income limits and these limits change yearly. So, if you’re faced with some restrictions, then consider other options, such as the 529 types I’ve previously discussed.

UTMA/UGMA (Uniform Transfer/Gift to Minors Act)

This option is one more account you can set up if the ESA or 529 plans do not fit your situation. This option allows you to open an account for a minor, but you’ll need to appoint someone who serves as the custodian of the account (the donor and custodian may or may not be the same person). You can invest money into the account and receive a tax credit. A couple of downsides: the tax credit is not going to be as great as it would be with the ESA or 529 Plan. And then there’s the risk that when the minor turns 18, they can take this money and spend it however they like. Your child is not limited to using this money for college.

Tip: Here’s where to find out how much you need to save for college.

This is just a bird’s eye view of these accounts, and I’d suggest that you check out the details of each account further if you’re wondering which option to go with. In any case, you don’t want to be too conservative when saving for college, say, by using only insurance or savings bonds to fund your child’s future. These may seem like safe options, but in reality, they do not yield enough earnings to cover inflation over the years of saving. So, always go with an investment that is set up with tax credits or used specifically for college savings.

Why Not Open Several College Savings Accounts?

So what is the financial blogosphere doing on this front? A lot of folks are taking the “diversified” approach, which is to put money in more than one type of college savings account. You’d do something like this for a few reasons:

(1) First of all, you are allowed to open several college savings accounts. So if you wanted to have a prepaid plan, a 529 plan and a Coverdell ESA, that’s your prerogative.

(2) Since each account has both good and weaker points, you may want to have each type of account in order to cover all your bases.

I quite like how the puts it. Here’s a scenario for why you’d have a variety of such accounts. You may want to sign up for a 529 prepaid tuition plan so that you can lock in your tuition costs. But since this plan doesn’t cover certain qualified expenses like room and board, you may also want an investment based tax-advantaged account to help you with that. So you may decide to go with the 529 savings plan as well, which allows you to save and invest a huge chunk, given the higher contribution limits. Now if you’d like to take advantage of tax-free investment growth for funds which you can also use towards elementary and high school expenses, then you can go for a Coverdell Education Savings Account, provided that your income does not limit you from making contributions.

If you have a lot of discretionary income, which plan (or plans) would you own?

Copyright © 2011 The Digerati Life. All Rights Reserved.

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