Opening a College Savings Account: Advantages and Disadvantages


Defined Tag: College Savings Account.

Opening a College Savings Account: Advantages and Disadvantages of Using a 529 Qualified Tuition or Pre-paid Tuition Plan or a Similar Education Savings Account

If you are a parent, grandparent, or legal guardian of a child who is interested in saving for his or her higher education, there are many options that can help alleviate some of the tax burden from that investment. Unlike money in a parent, grandparent, or legal guardian’s name, money invested in a child’s college savings account such as a 529 Qualified Tuition Plan, a 529 Prepaid Tuition plan, or an Education Savings Account (ESA) like a Coverdell can be allowed to gain interest federal tax-free.

Opening a college savings account in a child’s name can also offer more than just a federal tax break for the capital gains tax. Most states also allow tax benefits for either a college savings account or a prepaid tuition plan, although some states may have a limit on how much of an investment will receive a tax break. Withdrawals made from a college savings account or prepaid tuition plan not spent on qualified purchased may be taxed and penalized through the Internal Revenue Service. These penalties may not apply, however, under special circumstances such as receiving a scholarship, acquiring a disability or dying.

Shopping for a college savings account doesn’t just limit a buyer to the 529 Qualified Tuition Plans or 529 Prepaid Tuition Plans. Other options, such as the Coverdell Education Savings Account, will cover not just college costs but also any qualified elementary and secondary school purchases. Like the 529 College Savings Account and 529 Prepaid Tuition Plan, the Coverdell Education Savings Account penalizes for purchases not qualified.

Eligibility for either the 529 College savings account or the 529 Prepaid Tuition Plan in most states includes anyone regardless of state of residence. However, in some states, either the account holder (student) or the contributor must live in the state the college savings account, prepaid tuition plan, or educational savings account was purchased.

One disadvantage to using a 529 plan or other ESA is the limit on total contributions that having a typical savings or investment account would not have. Depending on the state from which the 529 or ESA account was purchased, limits can be capped as high as $300,000 total for a 529 college savings account or $2,000 annually for a Coverdell ESA. Plans may also have limits on how much of an annual gift can be contributed with tax exemptions.