College Savings Account Options

There are a lot of different types of accounts that you can use to save for college.  But, certain accounts have advantages over others such as:

·         Tax deductions for contributions

·         Tax free accumulation and withdrawal

·         The impact on college financial aid

·         Who has control over the account

·         Accumulation rate

The types of college savings account that I will be covering in this article are:

·         529 accounts

·         Coverdell accounts (also know as ESA’s)

·         UTMA / UGMA accounts

·         Brokerage Accounts

·         Savings Accounts

To make it easy to compare and contrast each option, I will have a grading table at the beginning of each section that will provide you with some general information on each type of account, as well as my overall grade on the effectiveness of each college saving option.

529 Plans

I’ll start with my favorite which are 529 College Savings Plan accounts.  As a Financial Planner, I tend to favor 529 accounts as primary college savings vehicles due to the tax advantages associated with them.  Many states offer state income tax deductions for contributions up to specific dollar amounts, so there is an immediate tax benefit.  For example, New York provides a state tax deduction for up to $5,000 for single filers, and $10,000 for joint filers for contributions to NYS 529 accounts year. There is no income limitation for contributing to these accounts.

NOTE:  Every now and then I come across individuals that have 529 accounts outside of their home state and they could be missing out on state tax deductions.

However, the bigger tax benefit is that fact that all of the investment returns generated by these accounts can be withdrawn tax free, as long as they are used for a qualified college expense.  For example, if you deposit $5K into a 529 account when your child is 2 years old, and it grows to $15,000 by the time they go to college, and you use the account to pay qualified expenses, you do not pay tax on any of the $15,000 that is withdrawn.  That is huge!!  With many of the other college savings options like UTMA or brokerage accounts, you have to pay tax on the gains.

There is also a control advantage, in that the parent, grandparent, or whoever establishes the accounts has full control as to when and how much is distributed from the account.  This is unlike UTMA / UGMA accounts, where once the child reaches a certain age, the child can do whatever they want with the account without the account owner’s consent.

A 529 account does count against the financial aid calculation, but it is a minimal impact in most cases.  Since these accounts are typically owned by the parents, in the FAFSA formula, 5.6% of the balance would count against the financial aid reward.  So, if you have a $50,000 balance in a 529 account, it would only set you back $2,800 per year in financial aid.

I gave these account an “A” for an accumulation rating because they have a lot of investment option available, and account owners can be as aggressive or conservative as they would like with these accounts.  Many states also offer “age based portfolios” where the account is allocated based on the age of the child, and when the will turn 18.  These portfolios automatically become more conservative as they get closer to the college start date.

The contributions limits to these accounts are also very high.  Lifetime contributions can total $400,000 or more (depending on your state) per beneficiary.

Coverdell Accounts (Education Savings Accounts)

Coverdell accounts have some of the benefits associated with 529 accounts, but there are contribution and income restrictions associated with these types of accounts.  First, as of 2021, only taxpayers with adjusted gross income below $110,000 for single filers and $220,000 for joint filers are eligible to contribute to Coverdell accounts. 

The other main limiting factor is the contribution limits. You are limited to a $2,000 maximum contribution each year until the beneficiary’s 18th birthday.  Given the rising cost of college, it is difficult to accumulate enough in these accounts to reach the college savings goals for many families.  Similar to 529 accounts, these accounts are counted as an asset of the parents for purposes of financial aid.

The one advantage these accounts have over 529 accounts is that the balance can be used without limitations for qualified expenses to an elementary or secondary public, private, or religious school.  The federal rules recently changed for 529 accounts allowing these types of qualified withdrawal, but they are limited to $10,000 and depending on the state you live in, the state may not recognize these as qualified withdrawals from a 529 account. 

If there is money left over in these Coverdell account, they also have to be liquidated by the time the beneficiary of the account turns age 30.  529 accounts do not have this restriction.

UTMA & UGMA Accounts

UGMA & UTMA accounts get the lowest overall grade from me.  With these accounts, the child is technically the owner of the account.  While the child is a minor, the parent is often assigned as the custodian of the account. But once the child reaches legal age, which can be 18, 19, or 21, depending on the state you live in, the child is then awarded full control over the account. This can be a problem when your child decides at age 18 that buying a Porsche is a better idea than spending that money on college tuition. 

Also, because these accounts are technically owned by the child, they are a wrecking ball for the financial aid calculation.  As I mentioned before, when it is an asset of the parent, 5.6% of the balance counts against financial aid, but when it is an asset of the child, 20% of the account balance counts against financial aid. 

There are no special tax benefits associated with UTMA and UGMA accounts. No tax deductions for contributions and the child pays taxes on the gains.

Unlike 529 and Coverdell accounts, where you can change the beneficiary list on the account, with UTMA and UGMA accounts, the beneficiary named on the account cannot be changed.

Brokerage Accounts

Parents can use brokerage accounts to accumulate money for college instead of the cash sitting in their checking account earning 0.25% per year.   The disadvantage is the parents have to pay tax on all of the investment gains in the account once they liquidate them to pay for college. If the parents are in a higher tax bracket, they could lose up to 40%+ of those gains to taxes versus the 529 accounts where no taxes are paid on the appreciation.  But, it also has the double whammy that if the parents realize capital gains from the liquidation, their income will be higher in the FAFSA calculation two years from now. 

Sometimes, a brokerage account can complement a 529 account as part of a comprehensive college savings strategy. Many parents do not want to risk “over funding” a 529 account, so once the 529 accounts have hit a comfortable level, they will begin contributing the rest of the college savings to a brokerage account to maintain flexibility.

Savings Accounts

The pros and cons of a savings account owned by the parent or guardian of the child will have similar pros and cons of a brokerage account with one big drawback.  Last I checked, most savings accounts were earning under 1% in interest.  The cost of college since 1982 has increased by 6% per year (JP Morgan College Planning Essentials 2021).  If the cost of college is going up by 6% per year, and your savings is only earning 1% per year, even though the balance in your savings account did not drop, you are losing ground to the tune of 5% PER YEAR.   By having your college savings accounts invested in a 529, Coverdell, or brokerage account, it will at least provide you with the opportunity to keep pace with or exceed the inflation rate of college costs.

Can The Cost of College Keep Rising?

Let’s say the cost of attending college keeps rising at 6% per year, and you have a 2-year-old child that you want to send to state school which may cost $25,000 per year today. By the time they turn 18, it would cost $67,000 PER YEAR, times 4 years of college, which is $268,000 for a bachelor’s degree!  The response I usually get when people hear these number is “there is no way that they can allow that to happen!!”.  People were saying that 10 years ago, and guess what? It happened.  This is what makes having a solid college savings strategy so important for your overall financial plan.

NOTE: As Financial Planners, we are seeing a lot more retirees carry mortgages and HELOC’s into retirement and the reason is usually “I helped the kids pay for college”. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

DISCLOSURE: This material is for informational purposes only. Neither American Portfolios nor its Representatives provide tax, legal or accounting advice. Please consult your own tax, legal or accounting professional before making any decisions. Any opinions expressed in this forum are not the opinion or view of American Portfolios Financial Services, Inc. and have not been reviewed by the firm for completeness or accuracy. These opinions are subject to change at any time without notice. Any comments or postings are provided for informational purposes only and do not constitute an offer or a recommendation to buy or sell securities or other financial instruments. Readers should conduct their own review and exercise judgment prior to investing. Investments are not guaranteed, involve risk and may result in a loss of principal. Past performance does not guarantee future results. Investments are not suitable for all types of investors. Investment advisory services offered through Greenbush Financial Group, LLC. Greenbush Financial Group, LLC is a Registered Investment Advisor. Securities offered through American Portfolio Financial Services, Inc (APFS). Member FINRA/SIPC. Greenbush Financial Group, LLC is not affiliated with APFS. APFS is not affiliated with any other named business entity. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Guarantees apply to certain insurance and annuity products (not securities, variable or investment advisory products) and are subject to product terms, exclusions and limitations and the insurer's claims-paying ability and financial strength. Before investing, consider the investment objectives, risks, charges, and expenses of the annuity and its investment options. Please submit using the same generated coversheet for this submission number. Potential investors of 529 plans may get more favorable tax benefits from 529 plans sponsored by their own state. Consult your tax professional for how 529 tax treatments and account fees would apply to your particular situation. To determine which college saving option is right for you, please consult your tax and accounting advisors. Neither APFS nor its affiliates or financial professionals provide tax, legal or accounting advice. Please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about municipal fund securities, please obtain an offering statement and read it carefully before you invest. Investments in 529 college savings plans are neither FDIC insured nor guaranteed and may lose value.

Beware of Annuities

I’ll come right out and say “I’m not a fan of annuities”.  They tend to carry:

1)      Higher internal fees

2)      Surrender charges that prevent investors from getting out of them

3)      “Guarantees” that are inferior to alternative investment solutions

Unfortunately, annuities pay Financial Professionals a lot of money, which is why it is not uncommon for Investment Advisors to present them as a primary solution.  For example, some annuities pay Investment Professionals 5% - 8% of the amount invested, so if you invest $200,000 in the annuity, the advisor gets paid $10,000 to $16,000 as soon as you deposit the money to the annuity.  Compared to an Investment Advisor that may be charging you 1% per year to manage your portfolio, it will take them 5 to 8 years to earn that same amount.

To be fair, there are a few situations where I think annuities make sense, and I will share those with you in this article.  In general, however, I think investors should be very cautious when they are presented with an annuity as a primary investment solution, and I will explain why.

Fixed Annuities & Variable Annuities

There are two different types of annuities. Fixed annuities and variable annuities. Within those categories, there are a lot of different flavors, such as indexed annuities, guaranteed income benefits, non-qualified, qualified, etc.  Annuities are often issued by banks, investment firms, insurance companies, employer sponsored plan providers, or directly to the consumer.   It is important to understand that not all annuities are the same and they can vary greatly from provider to provider.  The points that I will be making in this article are my personal option based on my 20 years of experience in the investment industry.

Annuities Have High Fees

My biggest issue with annuities in general is the higher internal costs associated with them.  When you read the fine print, annuities can carry:

·         Commissions

·         Contract fees

·         Mortality expenses

·         Surrender fees

·         Rider fees

·         Mutual fund expense ratios

·         Penalties for surrender prior to age 59½

When you total all of those annual fees, it can sometimes be between 2% - 4% PER YEAR.  The obvious questions is, “How is your money supposed to grow if the insurance company is assessing fees of 2% - 4% per year?” 

Sub-Par Guarantees

The counter argument to this is that the insurance company is offering you “guarantees” in exchange for these higher fees.   During the annuity presentation, the broker might say “if you invest in this annuity, you are guaranteed not to lose any money. It can only make money”.  Who wouldn’t want that?  But the gains in these annuities are often either capped each year, or get chipped away by the large internal fees associated with the annuity contract.  So, even though you may not “lose money”, you may not be making as much as you could in a different investment solution.

Be The Insurance Company

At a high level, this is how insurance companies work. They sell you an annuity, then the insurance company turns around and invests your money, and hands you back a lower rate of return, often in the form of “guarantees”.  That is how they stay in business.   So, my question is “Why wouldn’t you just keep your money, invest it like the insurance would have, and you keep all of the gains”? 

The answer: Fear.  Most investments involve some level of risk, meaning you could lose money.  Annuity presentations prey on this fear.  They will usually show financial illustrations from recessions, such as when the market went down 30%, but the annuity lost no value.  For retirees, this can be very appealing, because the working years are over and now they just have their life savings to last them for the rest of their lives.

But like other successful investors, insurance companies rely on the historical returns of the stock market, which suggest that over longer periods of time (10+ year) the stock market tends to appreciate in value. See the charge of the S&P 500 Index below. Even with the pull backs and recessions, the value of the stock market has historically moved higher.

Annuity Surrender Fees Lock You In

The insurance company knows they are going to have your money for a long period of time because most annuities carry “surrender fees”.  Most surrender schedules last 5 – 10 YEARS!!  This means if you change your mind and want out of the annuity before the surrender period is up, the annuity company hits you with big fees.   So, before you write the check to fund the annuity, make sure it’s 100% the right decision.

Do Not Invest an IRA In An Annuity

This situation always baffles me.  We will come across investors that have an IRA invested in an annuity.  Annuities by themselves have the advantage of being “tax deferred vehicles” meaning you do not pay taxes on the gains accumulated in the annuity until you make a withdrawal.  You pay money to the insurance company to have that benefit since annuities are insurance products. 

An IRA by itself is also a tax deferred account.  You can choose to invest your IRA in whatever you want – cash, stocks, bonds, mutual funds, or an annuity.  So, here is my question: since an IRA is already tax deferred vehicle, why would you pay extra fees to an annuity company to invest it in a tax deferred annuity?  It makes no sense to me.

The answer, again, is usually fear.  An individual retires, they meet with an investment advisor that recommends that they rollover their 401(k) into an IRA, and uses the fear of losing money in the market to convince them to move their full 401(k) into an annuity product.  I completely understand the fear of losing money in retirement, and for some individuals it may make sense to put a portion of their retirement assets into something like an annuity that offers some guarantees. But in my experience, it rarely makes sense to invest the majority of your retirement assets in an annuity.

Guaranteed Minimum Income Benefits

Another sparkling gem associated with annuities that is often appealing to retirees are annuities that carry a GMIB, or “Guaranteed Minimum Income Benefit”.  These annuities are usually designed to go up by a “guaranteed” 5% - 8% per year, and then at a set age will pay you a set monthly amount for the rest of your life.  Now that sounds wonderful, but here is the catch that I want you to be aware of.  For most annuity companies, the value of your annuity associated with the “guaranteed increases” only matters if you annuitize the contract with that insurance company. After 10 years, if instead you decided to surrender the annuity, you typically do not receive those big, guaranteed increases, but instead get the actual value of the underlying investments less the big fees.  This is why there is often more than one “balance” illustrated on your annuity statement.

Here is the catch of the GMIB – when you go to turn it on, the annuity company decides what that fictitious GMIB balance will equal in the form of a monthly benefit for the rest of your life.  Also, with some annuities, they cap the guaranteed increase after a set number of years.  In general, what I have found is annuities that were issued with GMIB prior to 2008 tend to be fairly generous, because that was before the 2008/2009 recession. After 2008, the guarantees associated with these GMIB’s became less advantageous.

When Do Annuities Make Sense

I have given you the long list of reason why I am not a fan of annuities but there are a few situations where I think annuities can make sense:

1)      Overspending protection

2)      CD’s vs Fixed Annuity

Overspending Protection

When people retire, for the first time in their lives, they often have access to their 401(K), 403(b), or other retirement account.   Having a large dollar amount sitting in accounts that you have full access to can sometimes be a temptation to overspend, make renovation to your house, go on big vacations, etc. But when you retire, when the money is gone, it is gone.  For individuals that do not trust themselves to not spend through the money, turning that lump sum of money into a guaranteed money payment for the rest of their lives may be beneficial.  In these cases, it may make sense for an individual to purchase an annuity with their retirement dollars, because it lowers the risk of them running out of money in retirement.

CD’s vs Fixed Annuities

For individuals that have a large cash reserve, and do not want to take any risk, sometimes annuity companies will offer attractive fixed annuity rates.  For example, your bank may offer a 2 year CD at a 2%, but there may be an insurance company that will offer you a fixed annuity at a rate of 3.5% per year for 7 years.   The obvious benefit is a higher interest rate each year.  The downside is usually that the annuity carries surrender fees if you break the annuity before the maturity date.  But if you don’t see any need to access the cash before the end of the surrender period, it may be worth collecting the higher interest rate.

Final Advice

Selecting the right investment vehicle is a very important decision.  Before selecting an investment solution, it often makes sense to meet with a few different firms to listen to the approach of each advisor to determine which is the most appropriate for your financial situation. If you go into one of these meetings and an annuity is the only solution that is present, I would be very cautious about moving forward with that solution before you have vetted other options. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

DISCLOSURE: This material is for informational purposes only. Neither American Portfolios nor its Representatives provide tax, legal or accounting advice. Please consult your own tax, legal or accounting professional before making any decisions. Any opinions expressed in this forum are not the opinion or view of American Portfolios Financial Services, Inc. and have not been reviewed by the firm for completeness or accuracy. These opinions are subject to change at any time without notice. Any comments or postings are provided for informational purposes only and do not constitute an offer or a recommendation to buy or sell securities or other financial instruments. Readers should conduct their own review and exercise judgment prior to investing. Investments are not guaranteed, involve risk and may result in a loss of principal. Past performance does not guarantee future results. Investments are not suitable for all types of investors. Investment advisory services offered through Greenbush Financial Group, LLC. Greenbush Financial Group, LLC is a Registered Investment Advisor. Securities offered through American Portfolio Financial Services, Inc (APFS). Member FINRA/SIPC. Greenbush Financial Group, LLC is not affiliated with APFS. APFS is not affiliated with any other named business entity. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Guarantees apply to certain insurance and annuity products (not securities, variable or investment advisory products) and are subject to product terms, exclusions and limitations and the insurer's claims-paying ability and financial strength. Before investing, consider the investment objectives, risks, charges, and expenses of the annuity and its investment options. Please submit using the same generated coversheet for this submission number. Thank you.