Brian Sauter

Brian Sauter is CFP® Board certified and earned his MBA from San Diego State University's College of Business Administration with an emphasis in financial and tax planning. Along with his undergraduate degree, he also earned the Personal Financial Planning certificate from SDSU. Prior to working with a fee-only advisory firm, Brian held his FINRA series [...]

Newly updated for 2019: College costs are a challenge for parents and students alike. In this video, Senior Financial Planner Brian Sauter, CFP® walks through education savings plans that offer tax incentives and those that don’t, along with the rules, pros, and cons of each plan.

College savings plans with tax incentives:

  • 529 College Savings Plan
  • Coverdell Education Savings Account (ESA)
  • Pre-Paid Tuition Plans
  • Savings Bonds

College savings plans with no tax incentives:

  • Uniform Gifts to Minors Act (UGMA)
  • Uniform Transfer to Minors Act (UTMA)

Other potential sources of education funds:

  • Traditional IRAs or Roth IRAs
  • Standard taxable investment accounts


Saving for education can represent a big challenge for students and parents. Today we’re going to look at multiple options to save for education. We’re going to start up by looking at options that offer a tax incentive.

The most popular college savings plan is the 529 college savings plan. Every state and Washington D.C. now offers a 529 plan. Each plan is administered separately through the state and has a separate custodian through the state as well. Each custodian offers different investment options. Most do not require that you’re a resident of the state to invest in their plan. The best plan for an individual really depends on the preference of investment options, and also if their state offers a tax incentive. We’ll look at an example on that here in a second.

529 plans are simple to start with low contribution limits and minimal paperwork. When accounts are established, a beneficiary is named. Beneficiaries on the account can be changed to qualified members of the beneficiary’s family at any time without tax penalty. There are no income limits to contribute. Maximum contribution amounts by state will vary. Most people will limit their contribution amounts to the annual federal gift tax exclusion, which is $15,000 for individuals, $30,000 per couple with a 529 plan. You can also group those contribution amounts into five year lump sums, so it would be $75,000 per person, $150,000 per couple.

Contributions to a 529 plan are made with after-tax dollars. Contributions do not provide a federal tax deduction. Over 30 states do allow for a state tax deduction of some sort when the contribution is made. In order to qualify for that state’s deduction, you normally will have to use that state’s plan. The principle in the 529 plan grows tax-deferred. If the funds are used for qualified education expenses, the distribution will be tax-free.  Qualified expenses include things like tuition, room and board, textbooks, supplies, etc. The 2017 Tax Cuts and Jobs Act did expand the use for 529 plans to include things like private K through 12 education as well.

There are also some disadvantages to the 529 plan. Investment options may be limited. If the funds are distributed and not used for qualified education expense, there will be a 10 percent penalty on the growth from the account, and that growth will also be taxed as ordinary income in the year that is distributed. A 529 balance may reduce a student’s eligibility to receive needs-based education, and may also reduce their ability to use federal education tax credits.

So let’s look at an example of how a 529 plan would work. So for example, contributions go in when your child is young. $10,000. Now that contribution can be deductible, some portion of it at least, depending on the state. So I have two examples here: California is one of the states that does not offer any tax incentive on the contribution, where Arizona does offer a state deduction: $3,000 for a married couple, $1,500 for an individual. In both cases, federally there would be no tax deduction from the contribution. In our example the $10,000 contribution grows by $5,000 with the investment performance, and $15,000 would then be used for eligible educational expenses. If that’s the case, that $15,000 when it comes out would all be tax-free. If the $15,000 comes out and is not used for educational expenses, the growth, that $5,000, would be taxed as ordinary income. You’d also have a 10%t penalty on the distribution as well.

So if you live in a state like Arizona that offers a state benefit, you want to make sure that you use that state’s 529 plan. So as an example of how it works, California offers their 529 plan through the custodian ScholarShare, where Arizona offers their 529 plan through the custodian Fidelity. So if you live in a state that does not offer a state tax deduction for contributions, it really doesn’t matter from a tax perspective which state’s 529 plan that you use. You’re really more looking at what custodian you prefer or what investment options you prefer.

Next let’s look at the Coverdell Education Savings Account. Coverdells are very easy to setup and don’t have to go through a certain custodian the way a 529 plan does. Contribution amounts are maxed at $2,000 per year to the Coverdell, and the ability to contribute does have income limitations: $95,000 to $110,000 of adjusted gross income for an individual or $190,000 to $220,000 for a married couple.

Coverdell tax benefits are very similar to a 529 plan. Contributions to the Coverdell go in on an after-tax basis. As long as the growth in the account is used for education expenses, the distribution is tax-free. Similar to a 529 plan, if the distribution is not used for education expenses, you pay a 10 percent penalty on the growth and the distribution would be taxed as ordinary income as well.

Unlike the 529 plan, the Coverdell has an additional restriction where monies must be distributed by the time a beneficiary is age 30. If the funds are not distributed by the time the 30, they are forced to be distributed, the growth in the account is taxed as ordinary income, and you do get a 10 percent penalty on that as well. Similar to the 529 plan, balances in these accounts may reduce the student’s ability to receive needs-based aid and also to qualify for federal education tax credits.

Prepaid tuition plans, as the name implies, allows an individual to pre-purchase certain units of educational credit. Currently only eleven states are accepting new applications for these prepaid tuition credits. Savings bonds can be a popular option for some. Although the bonds do not need to be used for education expenses, interest on the series EE and I bonds issued after 1989 can be excluded from income when qualified education expenses are paid with that income. Additional requirements may need to be met to qualify, so check out the education planning page at TreasuryDirect.gov to see if these are right for you.

Now let’s look at some accounts that don’t offer tax benefits.  UGMA and UTMA accounts do not provide tax benefits for college savings the way a 529 or Coverdell account does, but maybe a good option for those unsure if their child will attend college, since the funds do not necessarily need to be used for education expenses. The UGMA, or Uniform Gift to Minors Act, and the UTMA, Uniform Transfer to Minors Act, are nothing more than custodial accounts which are used to hold or protect assets for minors. Once they reach the age of majority, they can then be distributed.

Traditional or Roth IRA accounts can be used as a source of education funds for the account holder, or others such as spouse, children, or grandchildren. The account holder can take a penalty-free distribution as long as the distributions are used for qualified education expenses. With a traditional IRA, although you would avoid that 10% penalty, you would still have to pay ordinary income on the distribution. The Roth IRA would be tax-free.

Although some account types have tax or other advantages when used to pay for educational expenses, some savers or investors may prefer the flexibility of a standard taxable investment account. For those who seek more flexibility, these options may be the perfect fit if you need assistance determining how to reach your educational goals, look us up at PureFinancial.com