When it comes to saving for college, 529 plans are the most popular choice available. But there are other ways you can save for college.
In this clip from Industry Focus: Financials, Motley Fool analyst Gaby Lapera and Director of Investment Planning Dan Caplinger discuss a couple of alternatives to 529 plans, including custodial accounts and Coverdell Education Savings Accounts. As Dan and Gaby talk about in this clip, custodial accounts give you more flexibility in choosing investments, but at the cost of losing parental control of assets when kids reach majority. Coverdell ESAs are available for educational expenses before college, but they have low contribution maximums that limit their usefulness. Nevertheless, both are worth a look to diversify your college savings strategies.
A full transcript follows the video.
This podcast was recorded on Aug. 29, 2016.
Gaby Lapera: The other thing that's really important to note about 529 plans is that you can only use these for qualified education expenses. That means, if you were a really good saver, or maybe your kid gets a scholarship and you don't have to pay for school at all, you can take the money out of the plan, but you're going to be hit with an earnings tax and a 10% withdrawal penalty. What you could do instead is you could change the plan into someone else's name, who might be going to college, or you could just leave it in there if you think your kid is going to go to grad school and not get a scholarship.
Dan Caplinger: There is an exemption, Gaby, for the scholarship situation. In general, you're absolutely right -- if you don't use that money for educational purposes, and you withdraw it, then all the earnings become taxable, you get hit with that extra penalty on top. But at some point, Congress figured out that it wasn't entirely fair to penalize people who were fortunate enough to get scholarships. So, what they did in that case was they wave that 10% penalty. You'll still pay income tax on the earnings that the money that went toward the scholarship came out of, but you don't have to hit that 10% penalty as well. So, that's one benefit. It's still a good idea, anytime, any chance you can get that scholarship, that's always the best move. And you're absolutely right -- if you have more than one child, you can change the beneficiary of the 529 plan to the other child and not have to pay any penalties on that, as well.
Lapera: This is totally a matter of opinion, but are there any 529 plans that you think are good to look into?
Caplinger: In general, the best 529 plans are the ones that have the lowest costs. You've heard us talk in previous shows about 401(k) plans, that some employers have have low cost 401(k)s, some employers have high-cost 401(k)s. The exact same thing is true in the 529 plan world. It's something that, you have to look at each individual state and figure out, "Are they charging me a lot? Are they charging me a little bit?" All the 529 plans will charge you an annual fee that's based on a percentage of the amount of money that you have under management.
The best situation is one where you can keep those expenses down to about 0.25% or less. I've seen some plans that start to approach 1% or even more, and that's something that you really need to be careful about. It can make it smart to look at a state even outside of your own state, if you can end up saving money in the long run. As small as those percentages sound, over 15-20 years, they really do add up.
Lapera: Absolutely. Let's talk about a couple other savings accounts that are available for parents. Custodial accounts, I think, are the other most popular option besides 529 plans.
Caplinger: That's right. Basically, what a custodial account is is, you opening up an investment account on behalf of your child. Most of these are set up under what's called the Uniform Transfer to Minors Act, or the Uniform Gift to Minors Act. It's basically something where you, the parent, have investing control over the account. There's no tax benefits really in terms of tax-free treatment of earnings. The earnings on the investment account, up to a certain amount, is taxable to the child at the child's tax rate, which is almost always lower than the parent's tax rate. Above a certain amount, the income gets treated as the parent's income for tax purposes, which means that you end up paying the tax at the higher amount.
The reason why people like custodial accounts is, there's no limitation on what you can invest in. The 529 plan itself dictates what your investment options are. If you want to invest in something else, you're out of luck. With a custodial account, you can invest in whatever you want to. You can get an account with a fund company, ETF company, with a regular broker. You can buy individual stocks and bonds and other investments. You can do pretty much whatever you want.
The downside of the custodial account, there's a couple. One is, for financial aid purposes, the custodial account is treated as the child's assets. So, when it comes time to qualify for financial aid, the school will expect the child to pay more of that money out of their account than they expect parents to contribute on the child's behalf. The other downside of the custodial account is, when the child reaches the age of majority, usually 18 years old in most states, the parent has to turn it over to the child. The parent no longer has the legal right to exercise control over the money in the custodial account. There's no guarantee that the child needs to use it for college. From a legal standpoint, they can spend it on whatever they want.
Lapera: Oh, wow, OK. And for some kids, that'll work out great. For other kids, that would work out terribly. I'm just thinking about some people that I've known in my past. (laughs)
Caplinger: Exactly. That's one reason why the 529 plan is as popular as it is. You get to keep control, as the parent, beyond 18, beyond 21. It's still pretty much in your control, and it goes directly to educational expenses.
