Evaluating choices for funding college

Bill Cass, CFP®, CPWA®

Bill Cass, CFP®, CPWA®, 05/25/22


Parents looking at future college expenses are already prioritizing the need to save as they seek to reduce the debt burden for their children and perhaps themselves.

Many families choose a savings plan based on tax treatment, ease of distribution, and impact on federal financial aid and other programs. In some cases it may make sense for families to use a mix of different savings options, including 529 college savings plans, UGMA/UTMA custodial accounts, and Roth IRAs. For example, while using a 529 plan for most of the savings dedicated to college expenses, it may make sense to hold a small portion of funds in a custodial account that may be used toward certain expenses (e.g. transportation), which are not currently considered qualified education expenses.

A number of federal tax benefits are available for individuals saving for higher education. See IRS Tax Benefits for Education (About Publication 970).

The following table illustrates the differences between these savings accounts.

College savings options

comparing 529 plans with custodial accounts and IRAs

*Federal tax-free distributions (taken after December 31, 2017). Earnings may be subject to state income taxes in certain states.

†Other types of financial aid calculations may differ from FAFSA.

‡Withdrawn earnings subject to federal tax and 10% penalty if not used for qualified expenses. A 529 plan can also be used to pay off student loans (up to $10,000 total).

§Roth distributions are free from taxes and penalty if the account is held for 5 years and there has been a qualifying event such as the account owner turning age 59½.

Over the past two decades, 529 college savings plans have emerged as the leading vehicle for funding education. Assets in 529 savings plans have grown substantially for more than a decade, and now total more than $450 billion, according to the Investment Company Institute. The total number of accounts reached exceeded 15 million in 2021 (College Savings Plans Network).

Assets in 529 plans have grown

529 assets have grown over decades

Source: Investment Company Institute, 2021.

529 savings plans expand

Originally established by Congress in 1996, 529 college savings plans were designed to cover tuition, room and board, and other expenses such as books. Since 2015, policy decisions have expanded the list of qualified expenses for distribution of 529 funds.

Prior to EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001), when the designated beneficiary withdrew the funds for "qualified higher education expenses" (defined in Section 529 to include tuition, fees, books, supplies, room and board, and equipment), such withdrawals were treated as taxable income to the recipient. Beginning in 2002, however, the Act exempted those withdrawals from income tax provided they are used for qualified higher educational expenses.

Another change introduced by EGTRRA involves rolling over the Section 529 plan from one state-sponsored plan to another. Prior to the Act, an account holder could only roll over from one plan to another if the designated beneficiary was changed to another family member. Today, a roll over to another Section 529 plan with the same beneficiary is allowed, provided that the roll over can be used only once in a 12-month period.

Starting in 2002 and several times since, policy decisions have expanded the tax benefits and list of qualified expenses for distribution of 529 funds:

Year Policy change
2015 Computer equipment, software and related technology, and services such as internet service
2017 Up to $10,000 worth of tuition expenses per year at an elementary or secondary school. This includes public, private, and parochial schools
2019 Up to $10,000 (in total, not annual) withdrawal for paying back student loans, and also registered apprenticeship programs are now a qualified expense
More changes could be on the horizon. Just last week, Senators Maggie Hassan and Susan Collins introduced a bipartisan bill to encourage families to save in 529 college savings plans. The Helping Parents Save for College Act provides low- and middle-income parents with a tax credit for contributions to 529 plans. The provision utilizes a Saver’s Credit, worth up to 50% or $4,000 of contributions made. The bill also as a retirement rollover option for plan beneficiaries who do not go to college, allowing them to move excess funds into their Roth IRA, without penalty.

To start planning and explore strategies to optimize savings for funding college, read “Early college planning for a growing family.”

For more information about 529 plans, see Putnam.com.

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