The College Saving Conundrum: 529’s vs ESA’s vs Custodian Accounts


If you’ve done homework to develop a college saving strategy for your child, you’re probably seeing numbers as high as $400,000 for a private school. If that’s your target, it’s best to start now with a consistent plan. If you invest $500 per month and get an 8% return over 18 years, you’ll wind up with about $240,000, a tad short. The numbers can be discouraging, but don’t despair;
there are other ways to fund a college education. There are loans, financial aid, scholarships, and tax credits, so consider the top number you see the rack rate, but not necessarily the amount that you’ll have to pay.

Regardless of the amount you wind up paying, start early, save often, and use the tools that will work best for you. There are several resources to use to stash cash and invest, which I’ll discuss below. What you should keep in mind is how schools view each one when doing their calculations for potential needs based financial aid. Typically colleges will expect parents to contribute up to approximately 6% of their assets, and up to 20% of the assets that are owned by the child. Let’s look at a few of the most common tools.

529 Plans
529’s come in two varieties, a pre-paid tuition plan that allows you to pay for future college tuition at today’s prices at member schools in a particular state, and a 529 College Savings Plan that allows the saver to use the funds for any school. The pre-paid tuition program is a good deal, albeit a bit restrictive. But if you know your kid positively will be going to school in a state with a pre-paid tuition program, it might be worth a look (sorry NJ, your state doesn’t have a pre-paid plan). The 529 College Savings Plans are administered by each individual state, and the rules can vary slightly, but at their core they are all the same type of account. Contributions go in with after tax monies, the assets grow tax free, and withdrawals are tax and penalty free as long as the assets are used for qualified higher education expenses. Residents are not limited to investing in their own state’s plan. Another state may offer a plan that performs better and has lower fees, so it pays to shop around. Some states do offer incentives for their resident’s to invest in their plans, for example, NJ residents who invest in NJ’s 529 can qualify for a college scholarship opportunity of up to $1,500 if the student is attending college in New Jersey, and a $25 annual maintenance fee is waived, but there are other factors such as overall fees and investment choices that may make one plan better over another. Also, the plan chosen does not affect which state the student must attend school in. An investor can live in NJ, invest in a plan from Nebraska and send a student to college in Pennsylvania.

529’s allow you to pack in a lot of assets. Anyone can set up an account and contribute for a future student, and most plans allow you to amass in excess of $300,000 in assets for college (amounts vary depending on the plan). One of the main benefits of a 529 is that the assets are in the account owner’s name and not the child’s, so the impact on future financial aid is less since only 5.64% of a parent’s assets are considered in calculations for financial aid versus 20% for a child’s assets.

Coverdell Account (Education Savings Accounts – ESA)
The Coverdell account has its plusses and minuses. Like the 529, you can contribute monies for a beneficiary’s qualified education expenses, and when withdrawn for a qualified expense the earnings are federal income tax free. Unlike the 529, the money can be invested in a broad range of investments, (stocks, bonds, mutual funds, etc) and the asset is considered as the parent’s asset, so less impact to financial aid than assets owned by the beneficiary. The upside of the Coverdell is the additional flexibility in qualified education expenses. Withdrawals can be used for your typical secondary education expenses (tuition, room & board, books, etc), but it can also be used for Junior’s expenses incurred during the K-12 years – so you can use it to pay for that private school. The downside is that it only allows a contribution of $2000 per year per beneficiary, much less than the 529, and if your income is too high you might not be able to contribute at all (phase out for joint filers starts at $190,000).

Custodian Accounts (UGMA/UTMA)
Unlike the 529 that has limits in the dollar amounts that can be held in the account, a custodian account is open ended. Stash as much as you want in here (of course any monies you contribute are still subject to gift tax limits), but know that assets in this account are irrevocable, so they must be used for the minor’s benefit, and when that minor turns age of majority (depends on the state, usually 18 or 21), those assets are theirs. So if Junior turns 18 and wants to buy a cool new car instead of use those assets for college, there’s nothing you can do about it (legally that is). As mentioned before, assets in a custodian belong to the student, so any financial aid calculations will assume that 20% of these assets can be applied to educational costs. It’s best to leverage a custodian account if you know that you likely won’t apply for financial aid. The custodian account is not a tax shelter like the 529 or Coverdell. It is a taxable account with some tax benefits (the first $1,000 of unearned income is tax free, the next $1,000 is taxed at a low 15%), but also with a whammy in the form of any unearned income over $2,000 getting taxed at the parent’s highest marginal rate. You need to determine if the flexibility of a custodian account is worth it for you. If you accumulated a large amount in a custodian account, it might be wise to direct future deposits to a 529 or Coverdell, and even consider moving some of the custodian account assets into a 529 before your child turns 18, which you can do (although there are some caveats that you need to be aware of before doing so).

Saving for a child’s college education can seem complicated, if not futile, but as Cofucius said, “a journey of a thousand miles begins with one step”. Your strategy will be unique to you because your circumstances are different than anyone else’s, so get with a professional advisor to talk through your options, and take that first step now.