Paying For College? Here's How To Use Those Savings Plans

So your child has been accepted to his or her dream school—or at least the college that offers the best fit. Congratulations! Now come the bills. It’s time to break open those education savings plans—529 plans, Coverdell accounts, and other college funding sources—and put them into action. 

If you’ve been saving diligently for college, you’re certainly a step ahead of the game, but the logistics of withdrawing your funds and properly allocating them can cause confusion. Here’s a handy guide.

How to Use 529 Plans, Coverdell Accounts, and More

Two popular college savings plans are 529s and Coverdell education savings accounts. These accounts are similar in a number of ways, such as allowing parents to withdraw any gains tax-free as long as they use the funds for qualified expenses, said Amy C. Motylewski, senior specialist, retirement and 529 products for TD Ameritrade.

“Those qualified expenses include tuition, room and board, and computer equipment,” she said.

One of the biggest mistakes parents make is spending money on unqualified expenses, Motylewski said. If that happens, parents will be stuck paying both federal taxes and a penalty of around 10 percent.

Another type of plan that parents, grandparents, and others often use for college expenses is the Uniform Gifts to Minors Act (UGMA). This irrevocable gift allows minors to own property, like securities, without the need to set up a special trust fund. The benefit of a UGMA is that any gains are taxed at the minor’s tax rate. Monies spent out of the fund must be used to benefit the minor, but aren’t limited to education.

There are a few unique factors to keep in mind with UGMAs, Motylewski said. When the kid reaches the age of majority, he or she gains control over the money. Also, it’s considered the minor’s asset, which could be a tax or financial aid consideration in the future, she added.

Which Accounts First?

If you’re juggling several college savings accounts, you need to prioritize. Motylewski says parents should talk to a financial advisor before making withdrawals, but, in general, you should tap the tax-preferred accounts before you touch taxable accounts.

Did your kid get a scholarship to attend school? Not only is that fantastic; it also affects 529 withdrawals, in a good way.

“The great thing about 529s: if your child gets a scholarship, that money can come out without the penalty, equal to the amount of the scholarship,” Motylewski said.

Many investors review and rebalance their portfolios periodically, and for those of you who want to do that, she said you’re allowed two investment option changes annually for existing funds in a 529 plan, so think carefully. There is no restriction on how to allocate new funds, she adds. Coverdells and UGMA accounts don’t have investment change limits.

Think you’ll be lucky enough to have some cash left over after your kid gets his or her diploma? You have a couple of options. For Coverdells, the money needs to be used by the age of 30, so budget carefully. If your child plans to go to graduate school, funds from the 529 plan can be used to defray those qualified costs, she said.

Otherwise, the owner can change the beneficiary of the account to another person in the same family as the current beneficiary without tax consequences.

“The same rules apply—use it for qualified expenses. And family is broadly defined to be more than just a sibling,” she said.