What are my options to save for college costs?

October 05, 2020

College Savings Vehicles & Tax Treatments

There are a LOT of variables that go into this process, but for me it makes the most sense to start with the various account types and their pros and cons and tax treatments. 

There are 3 main options to invest for college that we will discuss here. 

1 - 529s

2 - Uniform Transfer to Minors Accounts (UTMA)

3 - After tax (non-retirement) investments

There are other options available but these are thought of most commonly.  The differences lie majorly in the tax treatment.  For me, it's probably easiest to put numbers to it, so here’s a quick crack at that.

First let's make a couple assumptions. 

You have a child, Pat, 8 years old.

You invest $20k over the next 10+ years and that investment grows to $40k by the time Pat is 18.

Here's what would happen in each of the 3 account types if the funds are used for college AND, since we don't know that Pat will attend college, it's equally as important that we examine the tax consequences should he/she choose another path.

In a 529:

If used for college (or primary/secondary school), the entire $40k is paid out with no taxes due.  So $40,000 after taxes.  You can find a list of qualifying expenses pretty easily with a web search and it’s pretty robust.

If the funds are not used for college expenses, the original $20k invested is paid out with no taxes due, but there are capital gains tax AND a 10% penalty on the growth of $20k.  Let’s say your long term capital gain rate is 15%, so that would be 15% of the growth ($20k) AND a 10% penalty on the growth. This means you would end up with $35,000 after taxes and penalty.

-Side bonus here if you live in Pennsylvania, any contributions to a 529 are deductible from your PA STATE income tax in the year you make the contribution.  I can check what your state's taxes allow should you be interested in a 529 and don't live in PA.  Contributions have no effect to Federal or Local taxable income.

-If you have more than one child, the account can be changed to the sibling as beneficiary at no penalty.  This reduces the risk of paying a penalty on assets not spent on college expenses.


In an UTMA:

Whether or not the funds are used for college, you would get a small tax break each year on any dividends earned in the account.  Let’s just say the dividends account for $2k of the $20k of growth.  You would get the original $20k + $2k dividends paid out with no taxes due and a long term capital gain tax on the remaining growth of $18k.  Long term capital gains are 15%, so you’d end up with $37,300 after taxes

-Negative to this option is when the child reaches your state's age of majority (PA is 21) the money becomes theirs no matter what, so you would lose control of the investment.


In a non-retirement investment:

Same as UTMA except no small tax break on the dividends but you retain the assets indefinitely – so original $20k back free of tax and 15% long term capital gains tax on the $20k of growth = $37,000 after taxes.



Summary after tax chart:

Account type                     Net if used for college    Net if NOT used for college

529                                      $40,000                              $35,000

UTMA                                  $37,300                              $37,300

Non-retirement                    $37,000                              $37,000


So the 529 used for college is the best scenario, but the worst scenario is the 529 not used for college.  In any case, you’re only looking at a range of $5k between all of the outcomes in this example, but remember the more growth you get the more drastic the difference in the three tax treatments becomes, like if you invested $40k and it grew to $80k, the differences between the best and worst outcomes would be double what they show above ($10k).


For the UTMA, you would need to the child’s SSN to get the account setup.  For the Non-retirement / taxable account there is no timeframe as the assets are yours.  Technically for the 529 you could start to contribute by naming either yourself or a close relative as beneficiary and then switch the beneficiary after the child is born (no penalties).

After you've made the decision on which account type makes the most sense for you, then it's time to look at investment options.  Feel free to give me a shout at any stage in your process!



This article is meant to be general, and it is not investment or financial advice or a recommendation of any kind. Please consult your financial advisor before making financial decisions.

The hypothetical example is for illustration purposes only and is not intended to be representative of actual results or any specific investment, which will fluctuate in value. The determinations made by this example are not guarantees or projections, and no fees/expenses are included in the calculations which would reduce the figures shown. Please keep in mind that it is possible to lose money by investing and actual results will vary.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer's official statement, which can be obtained from your financial professional. Be sure to read carefully before investing.

There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.