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Six Questions to Ask Before Investing for College

529, Coverdell, UGMA/UTMA, Roth IRA, or what?

Christine Benz, director of personal finance, 08/26/2011

Not only are college costs sky-high and rising fast, but college savers also have to sort through an alphabet soup of options: 529 plans, Coverdell accounts, and UGMA/UTMA accounts, to name some of the most commonly used vehicles. College savers also have to consider how financial aid fits into the mix and whether any of these vehicles jeopardize their eligibility for it.

Here are six questions to ask when determining which type of college-savings vehicle makes the most sense for you.

How much do you plan to contribute to college savings per year until your child goes to college?
If you plan to amass a lot of assets in a college savings fund, none of the major college-savings vehicles are automatically off-limits, but you may have to use them in conjunction with another vehicle. For example, the Coverdell Education Savings Account currently has a contribution limit of $2,000 per year. If you were planning to tap your Roth IRA to pay for college, that vehicle allows contributions of only $5,000 per year ($6,000 if you're over 50). If you'd like to contribute to just one type of college funding vehicle, a 529 plan or taxable account will allow you to amass the most assets.

Which vehicles are you eligible to contribute to?
In addition to limits on contributions, some of the college funding vehicles won't let you contribute (or receive tax breaks) if your income is over a certain threshold. Thus, the next step is to determine which of them you're eligible to contribute to.

The Coverdell Education Savings Account and Roth IRA both carry income limits; married couples filing jointly and earning more than $220,000 can't make a Coverdell contribution in 2011, and those married couples filing jointly who earn more than $179,000 can't fund a Roth IRA. (Not directly, anyway; higher-income savers can make a "backdoor" Roth IRA contribution. This fact sheet details the strategy.) And if your income comes in above a certain level, you can't take tax-free withdrawals from Series I or EE savings bonds, either. So, if your income level disqualifies you from any of these vehicles, you can cross it off your list.

How much flexibility do you need?
Are you determined to save for college and confident that you'll never need the money for another use? If so, you can feel free to consider dedicated college savings vehicles such as a 529 plan or Coverdell Education Savings Account.

If, on the other hand, you're looking for a college savings vehicle that will allow you to multitask--perhaps saving for retirement or shorter-term goals at the same time that you're saving for college--you'll want to shy away from 529 plans or Coverdells. That's because those vehicles require you to pay taxes and/or penalties if you need to withdraw the money prematurely or for another purpose. Instead, you should focus on a more versatile vehicle for college savings, such as Roth IRAs or taxable accounts. You can withdraw your Roth contributions at any time and for any reason (though it's rarely a good idea to rob your retirement account to pay for college). Saving and investing in a taxable account offers you the most ready access to your money, though you will have to pay taxes on any investment appreciation when you withdraw.

Do you expect that you'll need to rely on financial aid to fund your child's education?
If so, bear in mind that assets held in the child's name are generally less advantageous than assets in the parents' names when it comes to qualifying for financial aid. Coverdell accounts and 529 plans held by the parents have less effect on financial aid eligibility. UGMA/UTMA accounts, on the other hand, are less desirable if you expect that you'll be applying for financial aid.  

Does your state offer a generous tax deduction for contributions in its 529 college savings plan? Do you live in a state with a particularly high tax rate?
Currently, many states offer tax deductions if you invest in your home state's 529 plan, and a handful of states offer so-called tax parity, allowing residents to obtain a state-tax deduction even if they invest in another state's 529. If your state offers a large deduction and you live in a high tax state, that provides a strong incentive to prioritize a 529 plan over other types of college savings vehicles. Click on your state in our 529 Plan Center to view details about your state's plan and any tax deductions that your state offers for staying in-state. (There are a few exceptions, but you generally won't be able to receive a state tax deduction if you buy a 529 plan offered by another state.)

Keep the tax benefit in perspective, however. Because state tax deductions are capped at a fixed dollar amount, they'll tend to be less valuable, in percentage terms, the more you accumulate in the plan. Morningstar's research shows that savers who plan to amass a very large sum in a 529 plan will enjoy a lesser tax benefit, in percentage terms, than smaller investors. To learn more, read my article "Should 529 Investors Stay In-State or Shop Around?"

How much control would you like to exercise over your investments?
You can put almost anything inside Coverdell Education Savings Accounts, Roth IRAs, taxable accounts, and UGMA/UTMA accounts. While you can shop around among 529 plans, you'll still be choosing from a fixed menu of investment options.

Once you've answered the preceding questions, you should have a clearer view of the vehicle(s) that will work best for you. If you've decided to invest in a Coverdell, UGMA/UTMA, Roth IRA, or in your own taxable account, you can set that up by contacting the investment provider directly. If a 529 looks like your best option, Morningstar's 529 Plan Center provides a good starting point.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances. Copyright (c) MMX by Morningstar, Inc.

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