Saving for College

Which is the best plan for you?

529s, Coverdell ESAs and UGMA/UTMA Accounts

by Glenn R. Swift

You’re the proud parent of a brand new baby and already you’re thinking about putting money aside for college. Well, you’re thinking the right way because the value of a college education has never been greater. In fact, a study by the Pew Research Center released in February 2014 showed that the earnings gap between young adults with and without bachelor’s degrees has stretched to its widest level in nearly half a century. Of course, you’ve also heard that “college tuition has been rising faster than the rate of inflation” for about as long as you can remember. So, the message should be clear—start saving as early as you can. Even modest amounts of money invested prudently can make a considerable difference down the road. Then again, the really good news is that saving for a college education is so important that the government is going to help you do it.

There are four plans available to you, all with specific tax advantages (some more than others): 529 Savings Plans, 529 Prepaid Tuition Plans, Coverdell Education Savings Accounts and Uniform Gift to Minors Act (UGMA) accounts. Here’s a basic summary along with the key benefits of each so that you can decide which account is best for you and your family.

529 Savings Plans

Named after Section 529 of the Internal Revenue Code and legally referred to as a Qualified Tuition Plan, these plans are sponsored by the various states (every state except Washington has at least one) and managed by financial institutions specifically approved by the state for this purpose. Generally speaking, they work like an IRA or 401(k) retirement account. Cash contributions are made to an individual account established and managed for a named beneficiary. Funds available for higher education expenses depend upon the amounts contributed and the investment performance of the account.

You should bear in mind that neither the account owner nor the beneficiary is allowed to direct the investments in a 529 Savings Plan. However, account owners are permitted to choose among a number of broad investment strategies established by the program sponsor. Generally, a change in investment strategy is permitted at least once a year or if a new beneficiary is named.

Here are some of the key benefits of a 529 Savings Plan:

  • Although contributions to these programs are not tax deductible, under federal law growth in the account is tax-deferred.
  • Withdrawals for qualified higher education expenses are paid directly to the educational institution and are federal income tax-free. Generally, tuition, fees, books, supplies and equipment required for attendance qualify. Reasonable costs of room and board are also included if the student is attending school at least half time.  (Please note that state and local law can vary widely. Therefore, contributions and distributions may or may not be tax exempt from state and/or local income tax.)
  • Everyone is eligible to take advantage of a 529 plan, and the amounts that can be put in are substantial (over $300,000 per beneficiary in many state plans). Generally, there are no income limitations or age restrictions on donors.
  • No federal gift tax will be payable if a contribution does not exceed the annual exclusion limits by the Internal Revenue Service (currently $28,000 for a married couple, $14,000 for a single taxpayer). However, the donor may elect to treat contributions as having been made over a five-year period. Thus, an individual could contribute up to $70,000 for a single beneficiary in one calendar year and a married couple up to $140,000.
  • Contributions to a Qualified Tuition Plan of any type must be in cash and may not exceed the amount necessary to provide the beneficiary’s qualified higher education expenses. Program sponsors will specify maximum total contribution amounts based upon such factors as the beneficiary’s age, current education costs, projected inflation and anticipated investment returns. (Note:  Contributions may be made to both a Qualified Tuition Plan and a Coverdell ESA without penalty for the same beneficiary in the same year.)
  • Most accredited post-high school educational institutions offering associates, bachelors, graduate-level or professional degrees qualify as eligible educational institutions for a 529 Savings Plan. In addition, certain vocational schools may also qualify.
  • The donor maintains control of the account, and (with few exceptions) the named beneficiary has no rights to the funds. In fact, most plans allow you to reclaim the funds for yourself at any time. However, if a “non-qualified” withdrawal is made, the earnings portion will be subject to income tax and an additional 10% federal income tax penalty.
  • Although the assets in a 529 Savings Plan can be reclaimed by the donor at any time, the assets are not counted as part of the donor’s gross estate for estate tax purposes. Thus, 529 plans are often used as an estate planning tool to move assets outside of one’s estate while still retaining a measure of control if the money is needed in the future.
  • In most plans, (yes, there are exceptions) your choice of school is not affected by the state your 529 Savings Plan is established. Therefore, you can be a New Jersey resident, invest in a Connecticut plan and send your student to college in Florida and still take full advantage of the plan.

Of course, the rate of return of a 529 Savings Plan is determined by the performance of the investments held in the plan minus fees and expenses. This means that you cannot predict with certainty how your individual plan will perform over time.

529 Prepaid Tuition Planscollege_coinsinjar

Like its 529 counterpart, the 529 Prepaid Tuition Plan is established under the same section of the IRS tax code but works very differently. Prepaid tuition plans allow cash contributions to be made into a qualified trust to prepay at today’s prices some or all of a beneficiary’s undergraduate tuition costs. By avoiding increases in cost due to inflation, prepaid tuition plans encourage parents to save for their children’s education without having to worry about a volatile stock market. No matter how much tuition costs rise or how uncertain economic conditions may be, your prepaid tuition plan will increase in value at the same rate as college tuition. Of course, these plans cannot guarantee your child’s eventual admission to college.

Prepaid tuition plans are sometimes offered by private colleges. In fact, there is a group of more than 200 private colleges that collectively participates in a national prepaid tuition plan known as the Independent 529 Plan. However, by far the most common type of prepaid plans are those sponsored by the states.

Regardless of who is the sponsor, most prepaid tuition plans allow you to choose one or two methods of payment: a single, lump sum or a series of payments. In addition, anybody can contribute to a prepaid plan (parents, grandparents, friends, etc.).  Nevertheless, most states require that either the account owner or the beneficiary be a state resident when the account is opened. Regardless as to who is the plan sponsor, distributions for qualified educational expenses are completely tax-free at the federal level. Always keep in mind that state and local tax laws can vary considerably.

Prepaid plans fall into two categories: contract plans and unit plans. Under a contract plan, you are committed to purchasing a specified number of years of tuition in exchange for a lump sum or periodic payments. Contract plans usually offer lower prices for younger children since the state has more time to invest the money.

Unit plans offer you the chance to purchase a fixed percentage of tuition. (Typically, 1 unit represents 1% of a year’s tuition.) In a unit plan, everybody pays the same price for the units, and the price of a unit increases each year. Unlike a contract plan, you buy as many units as you want, whenever you want.


These plans can be a good deal if you are fairly sure that your children will want to attend college in your state. Plus, they may be a more stable savings vehicle than investment plans in a volatile stock market. This is particularly true because prepaid plans guarantee that contributions will match tuition inflation. The security of knowing that no matter what happens to costs you are locked in at today’s prices is a major attraction for many parents.


If your child decides not to attend an in-state school, some state-sponsored plans will only give you back your original investment. Still others will hit you with a cancellation fee. Also, if your child chooses not to go to school or you have to withdraw from the plan because you can’t meet the payment schedule, you may have to pay a substantial penalty.

Another drawback is that most of these plans only cover tuition, not other college expenses (room and board, textbooks, athletics fees, etc.). Furthermore, these plans can lower the amount of financial aid that a college might otherwise award you—a real problem if you expect to be eligible for substantial need-based assistance.

Bear in mind that restrictions apply to both state-sponsored and private college-sponsored plans with regard to eligibility, enrollment periods, tax liability, residency requirements, penalties, fees, etc. Because individual plans vary as much as they do, you should be very familiar with any prepaid tuition plan prior to investing.

Coverdell Education Savings Account (ESA)

A Coverdell Education Savings Account (ESA) is a tax-advantaged account designed to encourage savings to cover future education expenses (elementary, secondary, or college), such as tuition, books, uniform, etc. The tax treatment of Coverdell ESAs is much the same as that of 529 plans with a few important differences. Like a 529 plan, a Coverdell ESA allows your funds to grow tax deferred and proceeds to be withdrawn tax free for qualified education expenses at a qualified institution. However, the definition of qualified expenses in an ESA includes primary and secondary school, not just college like a 529.

Perhaps the biggest disadvantage of a Coverdell ESA is the much lower maximum contribution limit. For 2014, the total of all contributions to all Coverdell ESAs set up for the benefit of any one designated beneficiary cannot be more than $2,000 per year. This includes contributions (other than rollovers) to all of the beneficiary’s Coverdell ESAs from all sources. Remember, 529 plans generally have no restrictions on contributions up to the maximum lifetime contribution.

The rules for investments allowed in Coverdell ESAs are the same as those for IRAs, meaning an ESA can have almost any investment inside, including stocks, bonds and mutual funds, while 529 plans only allow a choice among a number of state-run allocation programs. Balances in a Coverdell ESA must be disbursed on qualified education expenses by the time the beneficiary is 30 years old or given to another family member below the age of 30 to avoid taxes and penalties; there is no age limit for 529 plans. Lastly, and also unlike a 529, the income level of a donor may affect contributions into a Coverdell ESA.

There are, however, some basic similarities between ESAs and 529s. With both plans, funds in the account are not considered the beneficiary’s money when applying for federal financial aid as long as the owner of the account is someone other than the beneficiary, such as a parent. This increases the child’s potential financial aid because parents are expected to contribute only 5.64% of their assets to finance college education, as opposed to the child’s 20%.

Another important similarity is that the custodian of both an ESA and a 529 plan can designate a new beneficiary without incurring taxes or penalties provided that the new beneficiary is an eligible family member of the previous beneficiary.


UGMA/UTMA Accounts

These are not nearly as popular as they were in the days before ESAs and 529s but can still be useful in the right circumstances, although those are few and far between. An acronym for the Uniform Gifts to Minors Act or the Uniform Transfers to Minors Act (depending on the state you live), these accounts are permissible in most states and allow assets such as securities, where the donor has given up all possession and control, to be held in the custodian’s name for the benefit of the minor without an attorney needing to set up a special trust fund. This allows a minor to have property set aside for the minor’s benefit and may result in an income tax benefit for the child’s parents. However, and this is a biggie, once the child reaches the age of majority (18 or 21 depending on the state), the assets become the sole property of the child and the child can use them for any purpose he/she desires. So, if you put money aside for your daughter in an UGMA or UTMA account and she runs off with an Italian race car driver the day after her 21st birthday (18 in some states) and spends the money in Las Vegas, oh well. Moreover, contributing money to an UGMA/UTMA account on another person’s behalf could be subject to gift tax; however, the IRS allows you to give up to the annual gift tax exclusion to another person without any gift tax consequences as long as total gifts are below the lifetime limits.

There is one silver lining. An UGMA/UTMA account allows for the assets to be taxed at the minor’s income tax bracket. Currently, beneficiaries under 19 (23 if a student) do not pay any tax on the first $1,000 of income; the second $1,000 is taxed at the minor’s rate (typically zero or 15%); and anything earned over $2,000 is taxed at the parent’s rate.

Another disadvantage with UGMA/UTMA accounts is that financial aid for college is typically reduced by 20-25% of the UGMA or UTMA balance. This is why many financial advisers suggest depleting the balance in these accounts for purposes such as summer camp, books, computer, etc. well before the minor begins applying to college.

Glenn R. Swift has been advising individual and corporate clients since 1979. If you’re interested in a complimentary portfolio review, please contact him at or call him directly at (772) 323-6925.

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