#244 – 529 Plans vs. Coverdell ESAs, Prepaid Tuition, Custodial, and Investment Accounts

Anna Sergunina: 00:00:01

Hey money boss parents Welcome back to the Money Boss Parent podcast. I am Anna Sergunina your host. And today I am continuing a conversation about comparing 529 college savings plan with other alternatives that many parents can consider. If if they want to go beyond just the traditional college savings plan. What I'm covering today are a few less traditional options, but they still exist. They're number one is covered Dell savings account. It's a formerly known as an educational IRA account, prepaid tuition plans, custodial accounts and investment accounts. So let's dive in. Now, I want to remind you that there is a full episode number 241 that you can go back to and kind of start from the beginning where I actually go into a lot of details of what 529 plans are, how they work, what their benefits, what their drawbacks and and I also compare those to Roth IRAs, and actual real estate properties. So if you want to look in depth and understand what those options are, I think it's a really good starting point. I also have a few other previous episodes that cover in depth, more information about what 529 college savings plans are, how do you get started? All the benefits that come with it? And also how do you maximize the benefits? And what are the best practices. So it's episode 210 and 211. I will make sure that these are linked in the show notes below so that you have a ton of information to go and dig into and really get your questions answered. So today, let's dive into further comparing the 529 college savings plans which should the most typical accounts are opened by parents again, one of the misconceptions is that because it is intended for college expenses, it is often mistaken that this account actually is for you know, for kids, it is for their education, but this account is owned by parents, kids of the beneficiaries. And so you have the choice of what you're going to do with it, and, and so forth. So it's for the kids, but it's not account that you open in their name. So one of the typical and less popular options out there with the 529 college savings plans is something called Coverdell Educational Savings Account, ESA, and as used to be called years ago when I just started in this industry educational IRA. Now it has a very similar structure and benefits as a 529 account. But the limits on this account of what you can contribute to it is very little. So honestly, over the years as a financial planner and working with countless families, I have seen maybe handful of families who had these accounts, because of some of these limitations that I will talk to you about today. But you need to know about it, it exists. And it also could provide some really good alternative options if you don't want to sort of feel like you were locked up and owning a 529 account. So it is also in a structure where money in that account grow tax free. If it's used for college related expenses, I'll give you a little cheat sheet on what it really actually entails. But allowing only to contribute $2,000 per year until your child earns eight turns 18. So I don't know for you, for me, that doesn't seem like a lot of money, knowing what the cost of college could be in the future. So I just want you to know that that's available. Now interesting enough that and then very Reese fairly recently, 529 accounts became available for families to use for K through 12 expenses. And so this is kinda like one of the features that Coverdell accounts had all along. So I liked that about that. So I actually had families who had both. And some of the monies in ESA accounts were more for like okay, if we needed to pay tuition expenses or books or mandatory fees for like private school or even like touring expenses while your child was going through, you know, K through 12 education this account was something that they could use. So there's more flexibility like one of the benefits here is that there is more flexibility of how the funds can you can be used, and especially in earlier years because we often think that To, you know, 529 is really devoted to college. And that's true. That's how it all started. But things changed over time. And in families choose to send their kids to different schools and, you know, alternative sin. So I think, I think these accounts are also adjusting from initially when they were created, also known, but also but changed over time. The fact that ESA accounts had broader investment options. And I want to argue against that, these days, because, again, so many more options exists today. But things like individual stocks or bonds, mutual funds, or index funds, all of those options actually a lot more popular these days, with 529 accounts. So if I was considering which one, which of these options to go with, I wouldn't be necessarily all only looking at like, wow, this account allows me to pick stocks, I'm just gonna go for that. That wouldn't be something that kind of tipped me over. To go with that account, I would personally would look at what's the limit? And how much can I contribute, because if it's only a few $1,000, that's like an extra account I have to keep track of. And that's a lot. So, but that's me, there are still really good options here. For a lot of you out there, I mentioned what expenses, you can pay out of these accounts such as tuition and mandatory fees, you can buy books, supplies, for for your students, computers, and you know, other equipment that's really like necessary for their degree in education. Now, the drawbacks, and there's just a few, one of them, that's kind of main for me, because I think it would put a lot of families out of eligibility to contribute to this accounts, but it's an income gap. So if you're as a family earning, and this is a little tax talk here, but modified adjusted gross income, when you look at your tax forms, tax form 1040, at the very bottom of that page, or as the page has changed, maybe second page, when you look at adjusted gross income or modified adjusted gross gross income, if it exceeds $110,000, for an individual, or a family, for $220,000. That means that you cannot contribute to these accounts. So if you're making $220,000 or more, you can't contribute to these accounts. So I think a lot of you'd be like, what's the you know, what's the point. The other thing that is better with 529 accounts is that whatever contributions you put in, for most states, like California doesn't have it. But for most states, you can actually also get a little deduction on your state income taxes, there is no state, there's no state deductions. There's no federal deductions for any contributions that go into these accounts. And last, but not least, one of the things that's going to happen if you own this type of account is that it's going to be counted in this formula. When you fill out FAFSA application, this is a standard form that every family fills out when their child starts college the first year and every year thereafter. And so basically, what it does is it assesses what your expected family contribution is towards college costs based on your assets, your income. And so this type of account will be assessed as 5.64%. So it's a typical percentage that's applied to a lot of other types of accounts. So just kind of highlighting that that may be something you don't want to have to deal with. If you do have one of these accounts, I would probably highly suggest for you to consider using it while your child still is in school, not college, right? Like maybe they're still in middle school in high school, and see where you can spend those dollars, right for whatever out of pocket expenses like tuition for tutoring school, like for example, I don't have an account like that. But Liam goes to Kumaon after school, homework type of activity, and they focus on math and reading. So I could see that I could be paying the tuition monthly tuition out of that account. So that's one so if anything, these accounts exist, it there's lots of good benefits about it, but also there's I feel like there's more drawbacks as compared to 529 plans. Okay. Let's move on to the next category. This is a less popular category of the same type of 529 college savings plans, except that it's referred to a lot as prepaid tuition plans. So I think a lot of people don't even realize that these prepaid tuition plans are actually our 529 college plans. So there are two types of 529 college plans typical, the most popular is a savings account or like an investment account. And that's where you're all really typically hear about the second type. And most states have that option, right, because it's a state sponsored and run program. And I'll explain further what how that all works is called prepaid tuition plans. Now, a lot of families have expressed interest over the years to be able to sort of fix the cost of college expenses, right? cost of tuition cost of room and board. And I agree with that, right? Because inflation on college costs traditionally has been a lot higher than inflation, we experience on normal things, except, you know, minus the COVID years, but in general, so the idea of pre paying the tuition, so think about this, if you have a child, let's use a five year old to feel like a five year old, still has quite a bit of time until they go to college. So if you looked at the college cost now, and said I'm willing to pay or prepay, whatever tuition it is today, and I know still have 13 years to go. And because inflation is high, I'm going to be saving right by paying for the for the costs today. So it's basically you bind future tuition at today's rates. And so it potentially could lead up to really significant significant savings. So everyone likes this idea. And all over the years, a lot of different states came up with options where you could steal like, you can buy prepaid tuition in chunks, like one semester or two semesters, you know, a whole year you can buy a hole for years, however you want. So it's really affordable. I've seen grandparents actually interesting side noticing grandparents, kind of buy these chunks of tuition, for for their grandkids, that sort of gifts. They've done it later on, because it was probably more clear to the family where the child was going to be attending college. So they have this was just addition, I also had families who pre paid for tuition at community colleges. Think about that, because the first two years

Anna Sergunina: 00:12:19

could be really inexpensive if you prepay these for these two tuition plans. And this is really only for tuition, if we're not talking about room and board for the first two years of community college. And if you've done a years in advance, there's a significant savings there. Now, some of you might be like, well, prepaying means like you have to come up with the cash, right? So let's say for tuition that the community college is like, I don't know, $5,000, for example, for a semester, you don't have to come up with $5,000. They have different payment plans. So you like you say I'm committing to paying for this block of time, one semester, two semesters, and so forth. So you can still have this like a payment plan associated with it. So I like that idea. It locks the tuition rates, it protects you against future increases, and it offers like really good savings into the future as well. Now, where I mentioned that these plans are typically ran and administered by the state that is offered. Back in the day, when I just started in financial planning, I used to volunteer for Maryland 529 college savings plan. And so they too have do two of these types of plans. The the 529 College Savings Plan is run by T Rowe Price to reprice is an investment company. So all the options in the plan will be offered through T Rowe Price funds. And they also have a prepaid tuition plan. And so prepaid tuition plan is administered by the state. And so what what also happens, right, because the state takes the money, somebody has to run the plan for you, because they're, you know, it's like a pension fund. If you think of this prepaid tuition plan, it's like a pension plan. You put money into it, they invest it for you. They also guarantee you that if in the future, and we know that's most likely to happen, it's going to cost in the example that I gave instead of $5,000, for tuition for one semester at the community college, if it's going to cost $7,000, they will cover the cost, right? Because what they've done over the years, hopefully the group the money to that point where they have enough to pay, so it reduces your financial risk. So a lot of states provide that guarantee, which for many people is very assuring because when you have an investment account, a typical 529 plan, and you invest in the stock market, in the bond market, and even in the savings account, right? You don't have a guarantee that there's going to be a dot balance market could change rates can go down. So that's the beauty of this type of account. But what it also kind of puts brakes for some families are these drawbacks, where like, it's, you really have to be certain that for example, your child will go to a specific school because what you're doing is that you're really trying to see how you can like zero on, like, locking in those tuition rates. Now I've had exam ball will only one family so far, but they've prepaid for this tuition for these kinds of, they bought the semesters, I think it over the year. So basically, they had a full prepaid tuition for their child to go to University of Maryland. And then later on, their child decided that she did not want to go to University of Maryland, she wanted to go go to a different school, and I can't remember now which school it was, but I know was out of state. So what this plan did is that it took whatever that balance was, right. So let's say the year that she goes to college, tuition for University of Maryland is $15,000 per semester, they would give her $15,000, she can take that amount, and go spend it at another school. That's it, right, they're not gonna give her the equivalent of what tuition is at that school, first of all, because it's out of state. And one of the things with these prepaid tuitions tuition plans is that it really is good. If you stay within the state, you can go to different schools, but as long as it's within the same state, they have limitations, right and what they can pay. So the family had to come up with a difference of how to cover you know, the cost of that school that that their daughter wanted to go to. So I firsthand seen that it could work if you have that kind of situation. And I also first hand seen how it does work when somebody does stay in, you know, unintended state at least. And this could potentially save quite a bit on these, you know, inflation increases. One thing I have never done, but I thought about it now is like calculated like, what's the difference? Like how much money did you really save by having this prepaid tuition plan versus invest in it on your own? And I know a lot of you may be thinking, Well, it depends on what timeline you'll look at. And this might be a conversation for another episode. So I just want you to know that there's there's some limitations with that. And really, the only last thing to mention here that it does cover tuition and like mandatory fees, but it does not cover room and board and other expenses. So you need to be planning for that. And if you have a child who might be staying at home, this might be a good alternative. I also think this might be sort of a good combo situation where you have an investment 529 type of account. And you also have a prepaid tuition, because then the other type will help you have funds for you know, other expenses that are not covered by this plan. So it's an alternative. And it's a great one. My next discussion here on the list would be to think about custodial accounts. We talked about custodial accounts, on this podcast in the past, because this is something that I think every parent should think about in terms of opening up for their children, I am referring to you GMA, and UTM, a unified unified gift to Minors Act, and unify transfer to mind and act. I think I got those, right. But I'll have this in the show notes. So these are accounts that are actually specifically intended for your kids. And you while the kids are still minors under the age of 18. In most states, you actually own account with them, when they turn 18, these accounts become their own. And so what this allows us parents to do is it allows them to present you know, present this opportunity for learning how to grow the funds, how to invest and so forth. Now, while you know, the parents are in charge of these accounts, these funds can be used for college, they're not intended for college, right? Because these accounts aren't specifically designed for that they're more like investment accounts for the kids. And the difference between the UDMA and UTM. A is the type of investments you can have in both, and I again, I've covered these in the past, and I'll have those previous episodes for you to check out. So if I think of those because a lot of times I hear parents say, Oh, we have a UTI ma account or like a grandparent setup one, that's great, but you need to keep this in mind at once your child is going to reach the age of majority. Usually it's a team. It's their account, and what if they choose not to spend money on college? I mean, I hope you'll never have to find yourself in that kind of situation. But things happen, right? People change their minds and so forth. So I would I would really think twice about using this As a you know, as an account that specifically is designated to, to pay for college expenses as compared to 529. Because there's a ton of benefits that that 529 has, that this account doesn't. And so there's no tax advantages, right? Like, no funds grow tax free, you actually do have to pay taxes on all the earnings and, and so forth. So it may not be the most tax friendly type of account, it's still a great option to grow it and you know, pass it on to the next generation. Now, it does have impact on the financial aid, which talked about this in context of Coverdale accounts, but assets in these accounts are considered to be child's accounts. So once they turn 18, if their account, and one of the things when you're filling out that FAFSA form, if the kids own accounts, they're the most, they're going to be the ones who are penalized the most. And so, for that family contribution calculation is going to be assessed to 20% of the account balance. Right, if the if the Coverdell account was like at 5.64, this is huge. So I just want to warn you about you know, thinking of this account is still a great option. And we're going to talk about this, why and what else to do. But in context of college focused, you know, tuition savings and ruin

Anna Sergunina: 00:21:23

board, I would I would put that up sort of at the bottom of the list if I was selecting accounts for for clients and for myself. Alright, my friends, one more option to consider because that's a typical place that I have clients who put money in, and it's just a typical investment account, you can open that at any place, Vanguard, Fidelity, Schwab, anywhere, it's just a brokerage account, that you can pick whatever type of investments you want, whether it's stocks, bonds, exchange, exchange traded funds, you can buy cryptocurrencies, I mean, it's a, it's it's a, an account that allows you to invest however you want. Now, because this account is just sort of Wild West, right? It's for anything and everything, it does not have all the specific features and benefits that exists with 529 college savings plans. So like all that tax free growth and deductions on the contributions in certain states. None of that exists. So you trading the flexibility of how you want to invest in what you want to invest in. And for the most part, I mentioned to like 529, college accounts have evolved over the years, there's a vast majority of very diversified investment options that are low cost, too. And if you really want to trade stocks, you can do that as well. So, and I again, I like the for you to think about this being sort of a combination, it's not one or the other. It's like how can I maximize all of the options for my family with having various accounts, right, maybe you don't need to have all of them, maybe you need to have one or two, right? Or maybe two or three, so that you can actually kind of cover yourself in whatever situation may come up. But again, a lot of times I have parents kind of pull back on me and say, Alright, I don't want to put all my money into the 529 college plan. Because I don't know if my child will go to college, or what if this happened, and what if that happens, and so forth, I get it, I feel the same concern right now, it's not a worry, because especially when you have your kids are younger, you don't know, right? What could be the situations and so forth. So having sort of plan B or Plan C as an alternative is a great option. So investment accounts, I mean, it's it's a typical investment account, you can, you can expect, you know, whatever returns, depending on you know, how aggressive or how conservative you invest the funds, you have a lot of flexibility, you can take the funds out whenever you want, you can move them around, you can add more, and so forth, you can also make this account to be sort of a general investment account, not just for college expenses, but for anything else that you need. So, you know, the flexibility is through the roof here, there's, you know, really no limits. Drawbacks, I would think about like, what's the market risk, and also taxation like taxes would be one of the things to really pay close attention to because any transaction you make an account if you sell it again, or if you're getting dividends right on like if your stocks are paying dividends or if you're earning interest on for example, you have bonds or like a savings account or savings account feature like maybe a money market, you paying taxes as you go when you sell investments inside those accounts out again, mentioned this already, you're going to pay taxes as well. There are there are opportunities to harvest losses, but I want to go there because the idea is for you to grow The money not to lose the money. So this is definitely an alternative. And it's something that you can totally tap into, I wouldn't specifically open a separate account and just kind of, you know, have that to be my plan B or C, as it relates to college costs, I would probably make this sort of like allocation, if I have an investment account, I would make allocation within that account, say, okay, maybe 15%, or whatever percentage you want 510 1520 or 50%, of my own investment account, or brokerage account, could be earmarked for college, because, you know, let's say I want more flexibility. Or let's say, I don't want to put all of the monies into this 529 account, that's when I would choose that as an alternative to 529 accounts, I think you probably getting my vibe, I think if we're talking specifically about college costs and savings options that you want to maximize, it really should come down to what your financial situation is, what kind of risk tolerance you want to take, what are your long term goals, right, like how much time you have, and then you look at these options, and you make your decision based on that 529 accounts. If we're talking about college savings, it's like the most straightforward options, it has a ton of tax advantages, it has all the investment options you need, doesn't need to be anything sophisticated. So you can't go wrong with that. But if you start to to want more flexibility or options to buy to Western in advance, or have opportunity to teach your kids, you know, investments, and you know, let them kind of play in it and also provide the opportunity to be in charge of it beyond college. That's your custodial accounts. And then of course, if you just want to have allocation inside your own investment account, you can. So the choice is yours, I just want you to have the right tools, and ideas of how these options work, so that you can start in the right place. So I don't think you're in the wrong place. If you have a 529 account already. And you're saving, just keep at it right, assess and come back and revisit and say Alright, are we on track? And this is a question that I think you should be asking yourself as a family every year, you know, maybe you still don't have clarity what your child is going to be like, but at least you've set a goal you wanted to save, you know, for a certain type of college? And are you staying on track with that? What, where and how it is saved? I think it's a secondary question. And as your kids get a little bit older, maybe you'll have more clarity. So here you have it, my friends, if you found this useful, please share I think grandparents are eligible to listen to this kind of episode because they could be helping with these right? They could be having these other accounts, they could be helping you contribute towards this big gigantic goal we all all have for our children. So share that with them. Your friends also would benefit I think tremendously by understanding what options exist and so forth. So please share this out. If you found this helpful, or and to if you are doing something else. That's totally so how do you get off the charts in terms of how you saving for college? Let me know because maybe I haven't covered it or haven't thought about it. And we'd love to maybe cover on the next episode here. So thanks so much for tuning in. Please don't forget to leave me a review. Always appreciate getting your comments and feedback. And until next time, remember you are the bosses of your own money.