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 fromIndustry 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.
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A full transcript follows the video.
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This podcast was recorded on Aug. 29, 2016.
Gaby Lapera: The other thing that's really importantto note about 529 plans is that you canonly use these for qualified education expenses. That means,if you were a really good saver, or maybe your kid gets a scholarshipand 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 isyou could change the plan into someone else's name,who might be going to college, or you could just leave it in thereif you think your kid is going to go to grad schooland 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 moneyfor educational purposes, and you withdraw it,then all the earnings become taxable, you get hit with thatextra penalty on top. But at some point,Congress figured out that it wasn't entirely fair topenalize people who were fortunate enough to get scholarships. So, what they did in that case was they wave that 10% penalty. You'll still payincome tax on the earnings that themoney 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 istotally a matter of opinion, but are thereany 529 plans that you thinkare good to look into?Caplinger:In general, the best 529 plans arethe ones that have the lowest costs. You'veheard us talk in previous shows about 401(k) plans, thatsome employers have have low cost 401(k)s, some employers have high-cost 401(k)s. Theexact 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 anannual fee that's based on a percentageof the amount of money that you have under management.
Thebest situation is one where you can keepthose expenses down to about 0.25% or less. I've seen some plans thatstart to approach 1% or even more,and that's something that you really need to be careful about. It canmake it smart to look at a state even outside of your own state,if you can end up saving money in the long run. Assmall as those percentages sound, over 15-20 years,they really do add up.Lapera:Absolutely. Let'stalk about a couple other savings accounts that areavailable 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'sbasically something where you, the parent, haveinvesting 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. Thereason why people like custodial accounts is,there's no limitation on what you can invest in. The529 plan itself dictates whatyour 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 dopretty much whatever you want. The downside ofthe custodial account, there's a couple. One is, forfinancial 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 thecustodial account is, when the child reachesthe age of majority, usually 18 years oldin most states, the parenthas to turn it over to the child. Theparent 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 knownin my past. (laughs)Caplinger:Exactly. That'sone 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 stillpretty much in your control,and it goes directly to educational expenses.
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