If you have children in the family, one of your goals is probably to set aside funds for their education. While Schwab recommends saving for retirement before saving for college, your personal priorities should be your guide. But remember—while your child may be able to get a loan for college, you can’t get one for retirement.
The examples assume a 6% annual return, composed of 2% interest income and 6% long-term capital gains. Interest income is taxed at a 35% ordinary income tax rate, while capital gains are taxed at 15% throughout the 15-year period. This represents a hypothetical investment and is for illustrative purposes only; the actual rate of return will fluctuate with market conditions and is subject to changes in tax law. Not intended to predict or project the performance of any specific investments.
Source: Schwab Center for Financial Research.
What’s the best college account for me?
|529 college savings plan||Education savings account (Coverdell)||Custodial account|
|Primary goal||Save for college||Supplement education expenses||Teach a child about investing|
|Tax advantages||Tax-free growth, tax-free withdrawals3||Tax-free growth, tax-free withdrawals3||Growth taxed at special rates4|
|Contribution limit||$365,000 lifetime limit per beneficiary5||Annual limit of $2,000 (income limits apply)6||No limit|
|Gift limit without incurring gift tax||$70,000 ($140,000 per couple) in a single year7||$2,0008||$14,000 ($28,000 per couple)|
|Ownership||Adult, or child if custodial 529||Adult||Child at age 18 or 219|
|Financial aid impact||Minimal10||Minimal8||Potentially significant11|
|Age limits||None||Contributions can be made until beneficiary reaches age 18. All funds must be distributed to beneficiary by the time beneficiary reaches age 30.||Beneficiary must be under age 18 when account is opened.|
|Ability to change beneficiary||Anytime||Until beneficiary reaches age 30||Never|
What kinds of college financing options are available?
There are four sources you can draw from to pay for college:
Combining some or all of these sources can help you keep on track with your other investment goals— retirement, for example—and can provide tax benefits.
In what order should I fund and draw down multiple college savings plans?
Schwab recommends funding the Coverdell first—up to the maximum you’re eligible to contribute. Then if you can save more, fund the 529 to the extent you’re able (you can contribute to both in the same year). With a Coverdell, you’ll generally have more flexibility with respect to investment choices, and you can withdraw the money tax-free for qualified K–12 expenses as well as college. Otherwise, the two accounts are very similar. For more, see Get Smart About Saving for College.
Custodial accounts or trusts: What’s best for grandkids’ college education?
A custodial account can take the place of a trust in most cases, with a lot less hassle and cost. A custodial account generally has the same gift tax advantage as a trust—the ability to utilize the current annual gift tax exclusion because the gift represents a “present interest” even though the beneficiary has no control over how the money gets spent. In some cases, a trust may be preferable, despite the additional cost and paperwork, especially if there are special needs or the trustee wants to place restrictions on the use of the money beyond the age of 18 or 21. Keep in mind, however, that neither a custodial account nor a trust will offer any special income tax advantages. If your goal is to keep some control over the money while saving for education expenses in the most tax-efficient way possible, then consider a Coverdell Education Savings Account and/or a 529 college savings plan. In any event, you should consult on trust matters with a professional estate planner who’s an attorney or a CPA. For more, see Get Smart About Saving for College.