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By Christine Benz and Adam Zoll | 10-15-2013 12:00 PM

What Are My College-Savings Account Options?

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.

Note: This video is being featured as part of Morningstar's November 2013 Investor Starter Kit special report. This video originally appeared Oct. 21, 2013.

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.

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