Home>Video>What Are My College-Savings Options?

What Are My College-Savings Options?

Mon, 21 Oct 2013

Coverdells, UGMA/UTMAs, and 529s are among the most popular college-savings vehicles, and savers need to educate themselves on their best option for investing cost-effectively.

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Video Transcript

Christine Benz: We are talking about paying for college today, and I'd like to go through some of the key vehicles that people might use, the key mechanisms that they might use to pay for college. Let's start with paying for college just out of your household cash flow or maybe out of a taxable brokerage account that you've set aside. What are the pros and cons of doing that?

Adam Zoll: Among the pros obviously, is the fact that you have incredible flexibility in terms of the assets themselves. You're going to invest them however you like--in something risky or something very safe. You have access to the funds anytime you should need them. If a household emergency should arise, you can get to that money without a problem.

The downside is there are no tax-advantages to doing this, and I would argue that the accessibility of the money actually is a bit of a downside, as well, because you may be tempted to raid the money to, let's say, fix up the rec room [in your home] that you're tired of looking at. I think there are pros and cons to that strategy for sure.

Benz: Let's talk about UGMA/UTMA accounts, those are sometimes called kiddie trusts. What are the pros and cons of using those vehicles for college funding?

Zoll: These accounts, also known as custodial accounts, are accounts where the assets are considered the property of the child until the child reaches age 18 or 21 depending on the state. And among the advantages are that they can be invested in almost any kind of investment type from the safest things like certificates of deposit and savings accounts to riskier fare, such as the riskiest exchange-traded funds and mutual funds. So you've got a broad menu of potential options there.

Another advantage is there are some tax advantages because the assets and the gains from them are taxed at the minors tax rate, which is often very low, and it may even be nothing. It's a tax-advantaged account.

Among the downsides are the fact that the assets do become property of the minor when they reach age 18 or 21, and the minor has every right to take the money and use it as he wishes or may not wish to use it. They may not wish to use it for college. They may want to go backpacking through Europe with their friends, and you have no control over that because the assets are not your property. So, that's one thing to be aware of. There is also a negative financial aid implication with the UGMA/UTMA accounts because they are considered a student asset, which counts more negatively in the financial aid calculation than a family-owned asset would.

Benz: Let's talk about the Coverdell Education Savings Accounts. I have been a fan of these vehicles in part because they do allow a lot for a lot of flexibility, but there are some pros and cons associated with them.

Zoll: Right. This is a tax-advantaged account, so your investment grows tax-free and distributions are tax-free. I think one of the best things about the Coverdell accounts is the flexibility. They can be used not just for college expenses, but also for kindergarten through high school expenses. So if you have a child who's going to private school, is going to need private tutoring, or has other qualified educational expenses, you can use the Coverdell account for that. As you mentioned, they can be invested in a wide variety of different kinds of investment vehicles.

Among the downsides is there is an annual $2,000 contribution limit, which may work OK for certain educational expenses, but in saving for college, that's kind of a low threshold, a low cap for a lot of families and may not get them where they want to go in terms of saving for college. Another downside is that a lot of fund companies and brokerages simply aren't offering the Coverdells anymore, so getting access to one might be a challenge for some families.

Benz: Let's talk about the 529 segment. We've been seeing a lot of assets flow into 529 college-savings plans, but let's start with a specific type of 529 plan, which is the prepaid plan. Let's talk about how they work, why someone might consider them, and what people should know before they invest in them.

Zoll: Sure. The biggest selling point for the 529 prepaid plan is that it's basically a hedge against tuition inflation down the road. What you're doing is you're putting money in an account today and essentially buying credits at today's tuition rates, and those credits can be used years down the line and cashed in for a given amount of tuition.

[With a prepaid plan] you are protecting yourself from this tuition inflation that we've observed, whereas with a 529 savings account you're putting money in a more traditional investment vehicle, you're choosing from a menu of mutual funds, and you're building a portfolio that is invested typically in the stock market, for example. And then whatever that account is worth down the road is how much you have to apply to paying for qualified college expenses, but you don't have a direct inflation protection the way you do with the prepaid plan.

Benz: Are prepaid plans run by states, and that means that your child must go to an in-state school if he wants to take full advantage of that prepaid plan?

Zoll: Either the beneficiary or the account owner must reside in the state that the prepaid plan is from. Yes, one of limitations is geography.

Benz: Is the child then limited to going to that state school?

Zoll: Typically the way it works is that, in many cases, the child can use the credits that he's accrued in a specific state's plan, and for example, the state will weigh those based on the average in-state tuition at all of the state universities. And then he can use those credits at an out-of-state school or even a private school. However, one of the drawbacks of using the prepaid plan is that you are basically restricted in the amount that you can save in that type of account, and it very well may not cover the full cost of tuition at an out-of-state school or a private school.

Benz: Another type of 529 plan is the 529 college-savings account. Let's talk about how these plans are different from the prepaid plans that we just discussed.

Zoll: Right. With the 529 college-savings account, you're investing in a portfolio of mutual funds. It may be an age-based portfolio that is very heavy in equities when the beneficiary is at a younger age and slowly tilts to fixed income as the college date approaches, or the account holder may be able to choose a fixed portfolio at whatever allocation that he chooses.

But in general, the 529 college-savings plans do require that you choose from a fixed menu of investment options. Some of those plans are very robust in terms of the choices that they give to account holders; others are somewhat limited. There is also a range of fees involved where some offer a pretty good deal and others really have extra administrative fees and whatnot layered on there that's make them a bit cost-prohibitive in some cases.

Benz: Let's talk about how the tax treatment works of 529 plans. You're putting aftertax dollars into the accounts typically and maybe sometimes receiving a state tax break?

Zoll: Right. With 529 accounts, your contributions grow tax-free, the distributions are tax-free, and in over 30 states you can also get a state income tax deduction usually only if you contribute to that states' 529 plan. There is a real tax advantage almost straight through the process with the 529 plans, and that's one of the real selling points.

Benz: So distributions not for any old thing are tax-free; instead, they've got to be going toward certain costs?

Zoll: Right. Only certain qualified college expenses are covered in terms of tax redistributions. Things you might expect: tuition, fees, books, and room and board if the student is at least a half-time student at the school. For anything that is taken out for other reasons, you will pay a tax penalty on any earnings that have accrued in the account plus a 10% penalty on top of that. So you want to make sure that you're not putting money in a 529 account unless you're very confident that it will be used for college expenses.

Benz: Let's talk about the impact of 529 college-savings assets on financial aid.

Zoll: The 529 assets are generally considered the property of the account holder--the parents in many cases, but not exclusively parents. Aunts, uncles, grandparents, and even friends of the family can open a 529 account for virtually any beneficiary, and it's important to note they can do it in any state. They don't have to live in the state where they're opening the 529; they don't have to open a 529 in the state where the beneficiary lives.

Benz: So they may get that state tax break if they open a 529 in their home state.

Zoll: In their home state. That's generally how it works. In terms of financial aid, the financial aid formula in particular penalizes assets that are the property of the student, but 529 assets for dependent students are not considered a student asset. They're considered a family asset or whoever the account holder is.

In the case of a family-owned 529, it would still have a small impact on financial aid but nowhere near as great an impact as a student-held asset would. So, it's not true to say that there is no financial aid impact for the 529 savings account, but it is a pretty minimal financial aid impact.

Benz: That's really great advice Adam. Thank you for being here.

Zoll: Thank you.

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