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As a parent, surviving the present is already an ordeal; having to financially plan decades into the future as costs for education remain sky-high in the US is mind-numbing. When it comes to saving for college, there are so many different savings and investment account options to choose from. 529? UTMA? Roth IRA? HYSA? At first glance they all seem to be a jumble of numbers and letters, so let’s make sense of what each of these are.

Roth IRA (Individual Retirement Account)

A Roth IRA is a retirement account in which contributions from after-tax dollars can be invested and grow tax-free. Withdrawing an amount equal to or less than the sum that was originally contributed for any reason is penalty- and tax-free. Withdrawing account earnings are penalty- and tax-free as long as the account has been open for at least 5 years and the account holder is at least 59.5 years old.

The Roth IRA can be used as a vehicle for saving for higher education. Gains withdrawn are generally subject to a 10% penalty if the above conditions are not met, but if used for qualified higher education expenses, they can be withdrawn penalty-free. Because the distributions when used in this way still need to be reported as income on the FAFSA, your child’s financial aid will be reduced by 47% of the distribution amount the following year distributions are made.

Fun Fact: The “Roth” in Roth IRA is named after the late U.S. Sen. William Roth (R-Del.), a fiscal conservative who sought to increase access to IRAs.

529 Plan

A 529 plan is a tax-advantaged savings plan that grows tax-deferred until withdrawn. Withdrawals are exempt from federal and state income taxes if used for qualified educational expenses. Non-qualified withdrawals are subject to taxes plus a 10% penalty.

The general worry is that the 529 plan is very rigid in that you can only use the funds for education-related expenses else you incur a 10% penalty on the withdrawals. However, given the cost of education these days, it is hard to imagine overfunding for college. Point aside, in the event that there is extra money left over in the account, a benefit is that you can rollover up to a $35,000 lifetime limit into a Roth IRA, penalty-free, if the account has existed for at least 15 years.

UTMA (Uniform Transfers to Minors Act)

An UTMA account is a custodial account that allows an adult to store, manage, and protect assets for a minor until they become of age (age depends on state of residence). It is an extension of the UGMA (Uniform Gifts to Minors Act), which extends the original limits of cash and financial investments to a wider range of assets and any form of property (real estate, art, etc.).

The account and assets are property of the minor, which means that the managing custodian cannot withdraw the assets within the account for any personal reasons.

If the account generates income or capital gains, the first $1,300 is untaxed, $1,300-$2,600 is taxed at the child’s rate, and earnings above are taxed at parent’s highest marginal tax rate.

While there are minimal tax benefits, an UTMA is considered a trust without the complexity of hiring a lawyer or estate planning attorney. It is also incredibly flexible in that funds are not limited to education (in fact they can be withdrawn by the beneficiary for any reason) and there are no contribution limits.

High-Yield Savings Account

A high-yield savings account (HYSA) is the same as a standard savings account but pays a much higher yield on your money, often in the 4–5% range. The interest rate is calculated by taking compounding into account, which means you earn interest on the principal and on the interest it earns. How often the interest compounds depends on the account, but more frequent compounding can lead to a greater return.

A HYSA is incredibly flexible, allowing you to contribute, withdraw, transfer, and manage with minimal effort, but the drawback of an HYSA is it is not an investment account. Interest rates are prone to fluctuate unpredictably, rates will not keep up with inflation, and interest earned is taxable. This makes it great for short-term savings and storing emergency funds, but for long-term is not a vehicle for growth. Different institutions may also have different rules for maintaining a minimum balance for the best rates or monthly withdrawal limits.

Too Lazy; Didn’t Read

Verdict

Personally, my husband and I chose to open a 529 Plan to save for our daughter’s education because it allows us to maximize the growth of our investments tax-free. With so many things to track in life already, the limited investment options makes choosing an investment plan straightforward and the “set it and forget it” model gives us peace of mind without the stress of needing to keep track of yet another account.

While the main concern many people have with the 529 is a fear of over contributing or being unable to ultimately use it for education, we still like the transfer flexibility to use for other family members and option of rolling over unused funds into another tax-advantageous Roth IRA account.

DISCLAIMERS & DISCLOSURES

This content is for education and information purposes only. Karen does not provide tax or investment advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. All investing involves risk, including the possible loss of principal.

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