Understanding College Savings Accounts
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Figuring out how to pay for college can be a challenging task, and many families start saving up well in advance. Designated college savings accounts, which encourage you to build up your college fund by offering incentives and rewards, are a popular tool that families use to build and manage savings intended for college.
Whether you already have a college savings account or your family is considering opening one, here’s what you need to know to better understand how creating a savings account will affect your college choices.
What is a college savings account?
A college savings account is a bank account with a twist: It’s specifically set up to handle the task of saving money for college. College savings accounts are usually set up by your parents or guardians in your name, but some also allow others to contribute to them as well. The most popular forms of college savings accounts are the 529 plan and the Education Savings Account, both of which we’ll describe in detail below.
Typically, these accounts offer incentives to encourage you to use that money only for educational expenses. These might include rewards like tax breaks, or penalties that discourage account holders from withdrawing money for other purposes.
Of course, it’s possible for your family to use a different kind of bank account, such as a regular savings account or a Roth IRA, to hold the money you’re planning to use for college. (Savings bonds are another option, but they function differently and don’t fall under the heading of college savings accounts.) This approach is potentially more flexible; for instance, it might allow you to more easily withdraw funds if you encounter an unforeseen emergency.
However, if your family doesn’t use a designated college savings account, you’ll miss out on the special benefits that come with it. You might also be more tempted to make withdrawals for non-educational reasons, even if it’s not an emergency. For these reasons, there are many families who choose to use college savings accounts.
How does a college savings account work?
On one level, college savings accounts work on a simple principle. The account is started by the account custodian, often your parent, with you listed as the beneficiary. Your family members, you yourself, or others in your life contribute money to that account over time.
The money you accumulate in college savings accounts is invested, and your account may accrue interest over time, increasing its value. Once you get to college, you can use the contents of your college savings account(s) to help pay for costs like tuition.
In practice, however, having and using a college savings account is somewhat more complicated. Different types of accounts have different requirements and restrictions, so you’ll have to do some research to determine the policies of your specific plan. If your family is considering starting one of these accounts, a broker or financial advisor can help you decide which type of plan is best for you.
Below, we’ll go over the basics of the two most common types of college savings accounts, including their benefits, their restrictions, and how to use them. We can’t cover every detail in this short post, but this information will help get you started.
Formally known as “qualified tuition plans,” these college savings accounts were created under section 529 of the Internal Revenue Code, hence their colloquial name. There are two major types of 529 plans, and depending where you live, you may have several different options.
The first type of 529 plan is the prepaid tuition plan. In this plan, your family will basically be able to use the money you save for college to prepurchase units of tuition from certain eligible colleges. This locks in your tuition rate, meaning that if tuition rises in the future (as it usually does), your family will have saved money by prepaying.
Typically, a 529 prepaid tuition plan can only be used for tuition and mandatory fees. Prepaid tuition plans also come with residency and age restrictions, and you can only enroll at certain times of the year.
The second type of 529 plan, the college savings plan, is somewhat more flexible. It creates a savings account that you can eventually use to cover tuition as well as certain other college expenses, such as housing and books. Not only can it be used for a wider range of expenses than a prepaid tuition plan, it can be used at a much larger number of colleges.
One downside of the 529 college savings plan is that unlike the prepaid tuition plan, it doesn’t let you lock in a lower rate for tuition. Another is that your investment isn’t guaranteed, meaning that the amount of interest you earn depends upon market conditions, and your 529 plan might even decline in value.
Both types of 529 plans provide tax benefits; for instance, contributors won’t pay federal income taxes on income placed in a 529 plan. If the account custodian withdraws money for a use besides qualified educational expenses, they’ll have to pay those taxes and an additional penalty at that time.
Educational Savings Accounts (ESAs)
ESAs, which are sometimes called Coverdell accounts, are similar to 529 plans in many ways — they allow your family to save up money for educational expenses while receiving incentives like tax advantages. However, there are a few key differences.
The defining feature of ESAs is that they can be used not only for college expenses, but also for educational expenses at primary and secondary schools. Your family could choose to withdraw funds from your ESA without a penalty to pay for private school tuition, uniforms, or certain other costs.
Some families may like the fact that ESAs provide you with more decision-making power regarding the investments upon which your account relies. (529 plans offer only a few choices.) The account custodian can choose to invest your funds in almost anything, and a good investment strategy could substantially increase the value of your account.
However, ESAs are also restricted in certain ways that 529 plans aren’t. For instance, contributions to your ESA are no longer accepted after you reach age 18, and you must use your ESA funds before you reach age 30.
ESAs also place significant limits on contributions. No matter how many ESAs are set up in your name and how many different people contribute to these ESAs, the total contribution to ESAs in your name each year can be no more than $2,000. 529 plans generally don’t have these limits, so they may be a better option if you anticipate larger contributions.
How do college savings accounts affect financial aid awards?
When you’re looking at forms of funding for college that are strictly merit-based and don’t consider your financial need, your college savings account doesn’t matter. Many scholarships, for instance, don’t take into account your ability to pay when determining awards (though some do).
When it comes to need-based financial aid, however, the assets you and your family already have matter quite a bit. Since a college savings account represents an asset on the part of the account custodian, usually your parent, it will be taken into account when calculating your financial need.
Simply put, money that your family has saved in your college savings account is money that your family doesn’t need to get from another source. If you have a college savings account, your financial need will be judged to be less than if you didn’t have that account.
At colleges that award financial aid based upon need, this will generally mean that you receive less aid. The same is true when it comes to need-based aid received from the federal government (including subsidized Federal Direct student loans) or from those scholarships and outside programs that consider financial need.
How much of a difference your college savings account will make in your financial aid award really depends upon how much money you have saved in that account. Just as with any other savings account or asset, the more you have, the greater the impact will be.
Something to keep in mind is that under current regulations, a college savings account is treated as an asset of the account custodian, not as an asset of the beneficiary (you). This may seem like a small difference, but it’s actually significant. Most need-based financial aid policies require students to contribute a larger proportion of their assets than their parents, so putting your money into a designated college savings account administered by your parent will likely affect your potential financial aid less than if you held that money in your own account.
Every college has slightly different financial aid policies, and these policies change over time. Speaking directly to the college’s financial aid office is the best way to determine exactly how your college savings account will impact your financial aid award at that specific school.
Is it worth it to start a college savings account?
Each family has a different financial situation, and there’s a fair amount of variation among different college savings account plans, so the answer to this question will be different for everyone. A professional financial advisor or broker will be able to give you the advice that’s most appropriate to your situation, but here are some factors to consider.
Having a college savings account involves paying fees, so cost can be an issue in deciding whether to open one of these accounts. You’ll need to be an informed consumer, research these fees, and decide whether they’re manageable in your situation. The amount of money you’ll save may or may not be enough to justify the fees involved and the hassle of creating a new account.
Timing is also important. The younger you are, the more potential setting up a college savings account has to benefit you. If you’re already in 11th or 12th grade, you’ll have less time to reap the benefits, and you may decide it’s not worth your time and money.
Finally, personal factors can come into play. For instance, if your family situation is more complicated than the stereotypical nuclear family, a college savings account with multiple contributors can potentially be an effective way to designate one central location for your college savings. Only you and your family can decide whether a college savings account is the most appropriate solution for you, but it’s certainly an approach that makes sense for many students.
For More Information
To learn more about your responsibilities and options when it comes to paying for college, check out these posts from the CollegeVine blog:
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