Saving for College: 529 Plans and Alternatives

The cost of a college education continues to climb at a pace that outstrips general inflation, making early and disciplined saving more important than ever. According to the College Board, the average annual cost of tuition and fees at a four-year public university has risen from about $3,500 in 1990 to over $7,600 in 2010 — and private institutions are significantly more expensive. For a child born today, the total cost of a four-year degree could easily exceed $200,000 at a public university and $400,000 at a private one. The good news is that several tax-advantaged savings vehicles exist to help families prepare, and starting early can dramatically reduce the burden.

529 Savings Plans: The Most Popular Choice

Named after Section 529 of the Internal Revenue Code, these state-sponsored plans have become the most widely used college savings vehicle in the country, and for good reason. They offer a combination of tax benefits, high contribution limits, and flexibility that is difficult to match.

How 529 Plans Work

You open an account, name a beneficiary (typically your child or grandchild), and contribute after-tax dollars. The money grows tax-deferred, and withdrawals used for qualified education expenses — including tuition, room and board, books, and required supplies — are completely free from federal income tax. Many states also offer a state income tax deduction or credit for contributions to their home-state plan.

Key Advantages

• High contribution limits: Most plans allow total account balances well in excess of $200,000, far beyond what other education accounts permit.
• No income limits: Unlike Coverdell ESAs and certain education credits, 529 plans are available to families at every income level.
• Flexible beneficiary changes: If the original beneficiary does not attend college, receives a scholarship, or does not use all the funds, you can change the beneficiary to another qualifying family member — a sibling, cousin, or even yourself — without tax consequences.
• Estate planning benefits: Contributions to a 529 plan are considered completed gifts for estate tax purposes. A unique five-year gift tax averaging election allows you to contribute up to five times the annual gift tax exclusion ($65,000 in 2010 for an individual, $130,000 for a married couple) in a single year without triggering gift tax.
• Minimal impact on financial aid: Assets in a parent-owned 529 plan are assessed at a maximum rate of 5.64 percent in the federal financial aid formula — far less than assets held in the student's name.

Choosing a 529 Plan

You are not limited to your home state's plan — you can open a 529 plan in any state. However, if your state offers a tax deduction for contributions, using the home-state plan may provide an additional benefit. When comparing plans, evaluate the following factors:

• Investment options and flexibility
• Total fees (expense ratios, annual account maintenance fees, enrollment fees)
• Historical investment performance
• State tax benefits for residents

The SEC's introduction to 529 plans provides an excellent overview of plan features and considerations.

529 Prepaid Tuition Plans

A second type of 529 plan allows you to purchase future tuition credits at today's prices, effectively locking in current rates. These plans are offered by a smaller number of states and typically cover tuition and mandatory fees at in-state public institutions. While they eliminate tuition inflation risk, they offer less flexibility than savings plans: if the beneficiary attends an out-of-state or private school, the payout may be limited to the value of in-state tuition.

Coverdell Education Savings Accounts

Coverdell ESAs (formerly Education IRAs) offer tax-free growth and withdrawals for qualified education expenses, similar to 529 plans. However, they differ in several important ways:

• Lower contribution limit: The annual contribution limit is $2,000 per beneficiary — far less than 529 plans.
• Income restrictions: The ability to contribute phases out for single filers with modified adjusted gross income above $95,000 and joint filers above $190,000.
• Broader eligible expenses: Coverdell accounts can be used for K-12 expenses (private school tuition, tutoring, books, computers) in addition to college costs. This is a significant advantage for families considering private primary or secondary education.
• Investment flexibility: Coverdell accounts can be held at most brokerages and can invest in individual stocks, bonds, mutual funds, and ETFs — offering more investment control than most 529 plans.
• Age restrictions: Funds must be used by the time the beneficiary turns 30, or the account must be transferred to another qualifying family member.

For families who qualify, a Coverdell ESA can complement a 529 plan — using the Coverdell for K-12 expenses or for its broader investment options, and the 529 for the bulk of college savings.

Custodial Accounts (UGMA/UTMA)

Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts allow you to hold assets in a child's name under adult custodianship. When the child reaches the age of majority (18 or 21, depending on the state), the assets transfer to them unconditionally.

The primary tax advantage is the "kiddie tax" rules: the first $950 of unearned income is tax-free, and the next $950 is taxed at the child's rate (typically 10 percent). Beyond $1,900, unearned income is taxed at the parent's marginal rate for children under 19 (or under 24 if a full-time student).

The biggest disadvantage of custodial accounts is their impact on financial aid. Because the assets legally belong to the child, they are assessed at 20 percent in the federal financial aid formula — roughly four times the rate of parent-owned 529 plans. Additionally, once the child reaches the age of majority, they have full control of the funds and can use them for any purpose, not just education.

Roth IRA as a College Savings Tool

While primarily a retirement savings vehicle, a Roth IRA offers a lesser-known benefit for college funding. Contributions (but not earnings) can be withdrawn at any time, tax-free and penalty-free, for any purpose — including education expenses. Additionally, Roth IRA distributions are not counted as income on the FAFSA in the year they are taken, which can be advantageous for financial aid calculations.

However, using retirement funds for college comes with an important trade-off: every dollar withdrawn for education is a dollar no longer compounding for retirement. Given that there are no loans for retirement but many options for financing education (scholarships, grants, federal loans), most financial advisors recommend prioritizing retirement savings and using dedicated education accounts for college.

Savings Bonds

Series EE and Series I U.S. Savings Bonds offer a modest but safe way to save for education. Interest earned on these bonds may be completely tax-free if used for qualified higher education expenses at an eligible institution, provided the bond owner meets certain income requirements. The bonds must be registered in the parent's name (not the child's) to qualify for the education exclusion.

While savings bonds offer safety and simplicity, their returns are typically lower than what a diversified investment portfolio would generate over an 18-year savings horizon. They are best used as a complement to, rather than a replacement for, 529 plans and other investment-based accounts.

Comparing the Options

Feature	529 Savings	Coverdell ESA	UGMA/UTMA
Annual contribution limit	Varies ($200K+ total)	$2,000	No limit
Income restrictions	None	Yes	None
Tax-free withdrawals	Qualified education	Qualified education (K-12 + college)	No
Financial aid impact	Low (parent asset)	Low (parent asset)	High (student asset)
Beneficiary can change	Yes	Yes	No

How Much Should You Save?

A common rule of thumb is to aim to save one-third of projected college costs, with the expectation that the remaining two-thirds will come from current income during the college years and financial aid (scholarships, grants, and reasonable student loans). Even saving a portion of the projected cost meaningfully reduces the need for student loans and the financial stress that accompanies them.

Starting when a child is born and saving $200 per month in a portfolio earning seven percent annually would produce approximately $86,000 by age 18 — enough to cover in-state tuition at many public universities. Increasing that to $400 per month would yield roughly $172,000, covering a significant portion of even private school costs.

Getting Started

The single most important factor in college savings success is time. The earlier you begin, the more you benefit from compound growth, and the less each monthly contribution needs to be. If you have not yet started saving for your child's education, today is the best day to begin. A financial advisor can help you select the right combination of savings vehicles based on your income, tax situation, number of children, and educational goals.

You cannot borrow for retirement, but you can borrow for college. Prioritize retirement savings, then direct every additional dollar toward education funding.

With disciplined saving and the right strategy, you can give your children the gift of a college education without jeopardizing your own financial security.