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Bottom Line Up Front

  • When it comes to saving for college, there are 4 college education savings accounts to choose from. 
  • When choosing which education savings account is right for you, make sure you understand the benefits. Check for tax-free interest earnings, tax-deductible contributions and contribution limits.

Time to Read

5 minutes

The sooner you start saving for college, the more funds you or your child will have available when the time comes. Even if you start putting money into a college savings account just a year or so before college, you or your child will still benefit. This is especially true when you combine your savings with other financial aid options, like student loans and grants.

College Education Savings Account Comparison

There are four primary college savings accounts that owners can explore. All of these can be opened for children; 529s and prepaid tuition are also available for adult students. Here’s a comparison:

Comparison Chart for College Savings Account Options
Features ESA 529 Custodial Prepaid Tuition
Earns federal tax-free interest Yes Yes No Maybe, in certain states
Earns state tax-free interest No Maybe, in certain states No Maybe, in certain states
Offers tax-free withdrawals for educational expenses Yes Yes No Yes
Offers tax-deductible contributions No Maybe, in certain states No Maybe, in certain states
Limits contributions Yes Yes No Maybe, in certain states
Permits transfer to another family member Yes Yes No Yes
Allowed for non-educational use Yes, with a penalty fee Yes, with a penalty fee Yes, without a penalty fee No
Open to children Yes Yes Yes Yes
Open to adults No Yes No Yes

ESAs

Coverdell Education Savings Accounts (ESAs, previously called education IRAs) allow you to make contributions to a tax-advantaged investment account.

ESA Features

  • Eligibility for children age 18 and younger
  • Contributions aren't tax-deductible and are capped at $2,000 per year per child
  • Earns interest tax-free
  • Funds are earmarked for educational expenses/college expenses
  • Funds withdrawn for educational expenses aren’t taxed; funds withdrawn for non-educational purposes are subject to a 10% penalty and taxes
  • Investor decides how to invest the funds, as well as distributions
  • Savings may increase or decrease in value depending on the investment portfolio’s performance based on chosen investment objectives
  • Account may be transferred to another member of the beneficiary’s family under age 30. Funds left in the account when the beneficiary reaches age 30 will incur taxes and a 10% penalty fee before being released to the beneficiary, not the ESA creator (or you can transfer the ESA to another member of the beneficiary’s family who is under age 30).

529 Plans

Most states operate 529 plans, which allow families to invest and grow savings tax-free and then later withdraw their savings, still tax-free, to use toward qualified K-12 tuition and qualified higher education expenses. These plans are similar to retirement funds in that they’re tax-advantaged, and you can choose from a selection of investment options through a brokerage, including mutual funds, stocks or bond portfolios. These plans get their name from Section 529 of the IRS code that created them.

529 Plan Features

  • Accounts can be set up for the investor or another beneficiary and can be transferred to another member of the beneficiary’s family
  • Earns federal interest tax-free. Some states also offer tax incentives and tax advantages.
  • Contributions are tax deductible in certain states
  • Funds are earmarked for educational expenses
  • Funds withdrawn for educational expenses aren’t taxed; funds withdrawn for non-educational purposes are subject to a 10% penalty and taxes
  • The investor chooses from a selection of investment options, as well as when and how to distribute the funds
  • Savings may increase or decrease in value depending on the investment’s performance
  • Investments don’t have to be in the state you live in, nor do you have to apply the funds toward a college in your state. For example, you can live in California and invest in a 529 plan in Vermont and attend college in Texas.
  • Private College 529 plans are available for select private colleges

Custodial Accounts

Annual gifts up to $16,000 (or $32,000 per couple) for each beneficiary aren’t subject to the federal gift tax per the Uniform Gifts to Minors Act.

  • Funds can be used for non-educational expenses without incurring a penalty
  • May only be opened for children ages 18 and younger
  • Contributions aren’t tax deductible
  • Account can’t be revoked or transferred to another beneficiary
  • Annual income taxes must be paid on account earnings as well as on the withdrawal when filing federal income tax
  • Funds in the account become the full property of the child when they reach a set age determined by state law and don’t have to go toward educational expenses

Prepaid Tuition Plans

Sometimes called guaranteed savings plans, these plans enable families to pre-purchase all or part of tuition expenses based on today’s rates at an in-state public college. When a beneficiary attends an eligible state college (or sometimes a private or out-of-state college), the program uses the funds to pay all or part of the tuition, regardless of whether tuition has increased over the years. The state absorbs the tuition increases. Be aware that some states may cap tuition contributions or end prepaid tuition plans altogether.

Prepaid Tuition Plan Features

  • Accounts can be set up for the investor or another beneficiary
  • Locks in today’s tuition prices
  • Some states offer a full or partial tax deduction for contributions to the state’s plan
  • Plan can be transferred to another member of the beneficiary’s family
  • Funds typically earn interest
  • Funds used for educational expenses aren’t taxed
  • Funds invested in a state-run prepaid plan can only be used at full value to pay for tuition and fees at in-state public colleges (you can use the funds for an out-of-state school, but not at full credit)

There’s a wealth of college savings options available. The important thing is to understand the advantages of each and choose the savings plan that works best for you. If you need advice, Navy Federal Investment Services can help you get started.

Key Takeaways

Disclosures

This content is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.