Education Savings: Gifting the Next Generation
By Adam Roberts, AIF®, CFP®
09/19/23
Families around the country are in the throes of adjusting to back-to-school activities, schedules, and homework routines. And while this season can feel busy and laborious, empty nesters are quick to remind young parents, “Enjoy this time, because high school graduation will be here before you know it.”
The advice may seem cliché, but it’s true. And given the rising costs of higher education, the message of urgency is particularly relevant when it comes to saving for college.
College funds offer students flexibility
I remember the day I left for college like it was yesterday. After saying goodbye to my parents, I hit the road, eager to embrace this next stage of life. I’d saved up enough money to rent a U-Haul truck, pay the first month’s rent, and cover a few weeks of food, gas, and other expenses.
Without a college savings account, I had two choices: Take out student loans or work full-time while attending classes. Unwilling to be saddled with debt, I opted to work. Between my determination and work ethic, I managed the demands of full-time work and school, but I had little time to invest in friendships, volunteer activities, campus organizations, or even self-care.
In contrast, my peers with college savings had more flexibility. They could choose to focus solely on their studies, intern in their field of interest, volunteer in the community, or serve other students by leading various campus organizations. When it came to work, they also had more options — work part-time during the school year, work full-time during the summers, piece together a few part-time gigs, or even hold out for a more desirable job.
My experience showed me first-hand that students with college savings had the advantage of flexibility and choice. And that’s why I encourage my clients to gift the children in their lives with a college savings account.
Ways to save for college: 529s, Coverdell ESAs, UTMAs
Opening a 529 account is the most popular way that parents, grandparents, and relatives help a child save for college. But there are situations when funding a Coverdell Education Savings Account (ESA) or Uniform Transfers to Minors Act (UTMA) could be preferred. Let’s take a look at all three options.
| Popular Education Savings Options |
| 529 Plans |
| These state-sponsored education savings plans offer tax-free growth and withdrawals for qualified expenses, but nonqualified withdrawals are subject to taxes and a 10% penalty. For 2023, individuals can contribute up to $17,000 per beneficiary ($34,000 for married couples), without triggering a gift tax. And those with significant assets often superfund 529 accounts for the income- and estate-tax benefits. Investment choices are selected by the 529 plan, you can change the beneficiary at any time, and certain states offer tax benefits to residents. The typical 529 investor is seeking a tax-advantaged method of saving for a child’s higher education or K-12 tuition. This client expects to save more than $2,000 a year, is satisfied with choosing from the plan’s predetermined investment options, and believes the tax-free growth justifies the fees. |
| Coverdell ESAs |
| These federally sponsored education savings accounts are only available to those earning less than the income threshold. Like 529 plans, they offer tax-free growth and withdrawals for qualified expenses, but nonqualified withdrawals are subject to taxes and a 10% penalty. Annual contributions are capped at $2,000 per beneficiary and must stop once the beneficiary turns 18. Coverdell ESAs allow you to invest in a wide range of securities, such as stocks, bonds, mutual funds, and more. All funds must be used, distributed, or transferred to another family member by age 30. The typical Coverdell ESA investor is seeking a tax-advantaged method of saving for a child’s higher education or K-12 tuition and expenses. This client wants a wide range of investment options, is seeking low fees, meets the income limit, and is satisfied with saving only $2,000 per year for each beneficiary. |
| UTMAs |
| These taxable accounts enable you to transfer various assets (e.g., cash, securities, real estate) without a traditional trust. And because UTMAs aren’t specific to college savings, they can provide funds to help with other financial milestones, such as purchasing a vehicle or first home. UTMAs transfer ownership at the age of majority (age 18 in many states), but there are ways to extend the age of majority to age 25. The typical UTMA investor is seeking to transfer various asset types to a minor, but without the cost and complexity of establishing a traditional trust. This client’s primary goal is to provide for the child’s overall financial well-being, which may or may not include education, and understands any growth is taxable. |
The benefit of saving early
Regardless of which account type you choose, saving early for college allows funds to benefit from the power of compounding. The earlier you start saving — even as little as $50 a month — the longer your money has to compound and grow. And, of course, those with the financial means to superfund a 529 account stand to benefit the most from compound interest.
To help illustrate the power of compound interest, let’s take a look at three families. They all contribute $21,600 to the child’s 529 plan, but at different times. As shown in the chart titled, “Compound interest and 529 plans,” Billy’s grandparents contribute $21,600 when he’s born, Mary’s aunt contributes $100 per month for 18 years, and Jaime’s parents begin contributing $200 per month on his 9th birthday.
Assuming all three accounts earn 8% interest (compounded annually) until they turn 18, Billy’s account will total $86,314, Mary’s will total $44,940, and Jamie’s will total $29,970. And while all three families contributed the same amount, Billy’s account value is significantly more than Mary’s and Jaime’s because the full $21,600 had longer to compound and grow.
While any amount you save will reduce the child’s financial burden, saving a large amount early provides the best opportunity to use compound growth to help offset rising education costs.
| Compound interest and 529 plans |
| Billy’s 529 plan | Mary’s 529 plan | Jaime’s 529 plan | |
| Initial contribution | $21,600 | $0 | $0 |
| Monthly contribution | $0 | $100/month | $200/month |
| Interest, compounded annually | 8% | 8% | 8% |
| Duration | 18 years | 18 years | 9 years |
| Total amount contributed | $21,600 | $21,600 | $21,600 |
| Ending account value | $86,314 | $44,940 | $29,970 |
Source: https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator
Common objections to saving for college
Over the years, clients have expressed various hesitations to opening a college savings account. Let’s take a look at some of the most common objections.
- My child could get a scholarship. You can withdraw the amount of the scholarship from your 529 without incurring the 10% penalty, but taxes will be due on the earnings.
- I can only save $50 a month, which won’t be enough. Any amount you save will help lessen the burden of paying for college. And, with the power of compounding, even small amounts can grow significantly over time.
- What if the child doesn’t go to college or I save more than the child needs? In these situations, a 529 provides options: (1) transfer it to another qualifying family member, (2) gradually roll over up to $35,000 in 529 plan assets into a Roth IRA (starting in 2024 and subject to SECURE 2.0 Act eligibility requirements), (3) pay off up to $10,000 in student loans for the beneficiary’s siblings, or (4) simply withdraw the money and pay the 10% penalty and any taxes due on the earnings.
- Children get more out of college when they help pay for it. Many parents and researchers alike assert that students with part-time jobs earn higher grades, manage their time better, and are more likely to graduate. With this in mind, a possible compromise could be to cover tuition and fees, but require the child to pay for room, board, and other expenses.
Consider giving a child the gift of flexibility
Whether you’re a parent, grandparent, or other relative, you have the opportunity to change a child’s future. By creating a college savings account, you’re gifting the child with choices, options, and flexibility.
Given the different features and benefits of 529 plans, Coverdell ESAs, and UTMAs, it’s important to work with your financial advisor to determine a strategy for meeting your education-savings goals.