Just like there are different ways to save for retirement, there are different ways to save for college. While 529 plan accounts generally offer the most tax advantages for saving for higher education, each savings option has pros and cons.
529 college savings plans
529 plan accounts are specifically designed to help investors save for higher education—offering tax benefits,* a variety of investment choices, and the flexibility to change beneficiaries (to an eligible family member of the original beneficiary).
However, the earnings in a 529 plan account will be subject to federal income tax, state and local income tax, and a 10% penalty tax if they're not used for qualified higher-education expenses.
Custodial accounts under the Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) allow you to save on behalf of a minor for education or any other purpose that benefits the minor (other than parental obligations like food, clothing, and shelter).
Contributions to an UGMA or UTMA are irrevocable. The beneficiary on the account can take ownership of the assets as soon as he or she reaches the age of majority (between ages 18 and 21, depending on the state). And because the assets in an UGMA/UTMA belong to the beneficiary, the beneficiary can never be changed.
Taxable (nonretirement) accounts, like checking or savings accounts and individual or joint investment accounts, give the account owner complete ownership of the account assets. Only adults can register for account ownership.
Taxable accounts have no contribution limit and no rules regarding what the assets can be used for, but there are no tax advantages for using the assets for educational expenses.
Tips on choosing your investments
Whichever account you use to save for your child's education, it's important to choose the right investments to help you reach your goals. The combination of stocks, bonds, and cash you choose—your asset allocation—will impact your investment returns and how your portfolio reacts to market ups and downs.
Trying to avoid market risk (the likelihood your investments will lose value with market movement) by holding only lower-risk investments such as money market and bond funds or CDs can expose you to other types of risk, like being unable to outpace inflation or reach your goals.
Diversification is a good way to manage many types of risk. Owning a portfolio that gives you "a little bit of everything" can balance out your exposure to both strong- and weak-performing areas of the market.
529 college savings plans: Invest for anyone's higher education.
UGMA/UTMA accounts: Invest for a minor and for any purpose.
Taxable accounts: Invest for anyone and for any purpose.
529 college savings plans: Change your beneficiary (to an eligible family member of the original beneficiary) at any time.
UGMA/UTMA accounts: Can't change your beneficiary.
Taxable accounts: Most nonretirement accounts don't have named beneficiaries.
529 college savings plans: Account belongs to the account owner.
UGMA/UTMA accounts: Account belongs to the account owner/custodian until child reaches the age of majority.
Taxable accounts: Account belongs to the account owner
Penalty-free withdrawals for …
529 college savings plans: Qualified higher-education expenses.
UGMA/UTMA accounts: Any expense that benefits the child.
Taxable accounts: Any expense.
State tax benefit
529 college savings plans: Contributions: may be state tax-deductible.
Earnings: generally not subject to state tax.
UGMA/UTMA accounts: Contributions: not state tax-deductible.
Earnings: subject to state tax.
Taxable accounts: Contributions: not state tax-deductible.
Earnings: subject to state tax.
Federal tax benefit
529 college savings plans: Earnings: generally not subject to federal tax (if used for qualified expenses).
UGMA/UTMA accounts: Earnings: subject to federal tax (rate depends on child's age).
Taxable accounts: Earnings: subject to federal tax (rate depends on account owner's tax rate).
529 college savings plans: Nonqualified withdrawals subject to federal income tax and a 10% penalty tax.
UGMA/UTMA accounts: No penalty if account assets aren't used for college.
Taxable accounts: Assets can be used for any expense without penalty.
529 college savings plans: Maximum contribution limit per beneficiary is generally between $200,000 and over $300,000, depending on the state.
UGMA/UTMA accounts: No maximum contribution limit, but amounts above $14,000 per year ($28,000 for married couples filing jointly) will incur federal gift tax.
Taxable accounts: No maximum contribution limit.