In our previous insight article, we explored future college costs. With tuition rising rapidly, starting a savings plan early and staying consistent is crucial. This first installment of a two-part series reviews the key college savings strategies available, including their benefits and trade-offs.
529 Plans
The most widely used of all college savings strategies are 529 plans. These state-sponsored investment accounts are tax-advantaged where earnings and qualified withdrawals are federally tax-free. Many states (including Alabama) offer a deduction or credit for contributions when filing state-tax returns. While you can generally join any state’s 529 plan regardless of residency, to gain the state tax benefits you need to contribute to your home state’s plan except for the nine “tax parity” states (Arizona, Arkansas, Kansas, Maine, Minnesota, Missouri, Montana, Ohio, Pennsylvania).
Contribution Flexibility
529 plans have no federal limit on annual contributions and states set the lifetime contribution limit per beneficiary, typically ranging from $235,000 to $600,000 (Alabama is $475,000). While you can contribute large amounts, most states limit the amount of the contribution that is deductible from state income taxes (Alabama is $5,000 for single-filers and $10,000 for joint-filers).
Additionally, there are no income limits for contributors to 529 plans which make them more accessible to a wider range of families. Beneficiaries can be changed at any time, providing flexibility if your child decides not to go to college.
Investment Options
529 plans typically offer a range of investment portfolios with less control over the specific individual investment choices. The majority of plans offer target-date funds which automatically adjust the mix of assets to more conservative investments as the beneficiary gets closer to college age.
Plans also usually offer static portfolios or individual investment options which maintain the investment allocation over time unless changed. Some plans allow you to change the investment portfolio during the year (up to twice per year in Alabama) or when changing the beneficiary.
Withdrawals
Withdrawals from a 529 plan that are used for qualified expenses are tax-free. However, the earnings portion of a non-qualified withdrawal is taxed as ordinary income plus a 10% penalty. Contributions, when withdrawn, are not taxed or penalized as they are made with after-tax dollars.
Qualified expenses include tuition, room and board, fees, books, supplies, computers, and equipment needed for courses. 529 plans can also be used to pay for student loan repayments (up to $10,000) and tuition at K-12 public, private, or religious schools (up to $20,000 starting in 2026). Additionally, professional certification, licenses, and registered apprenticeships (fees, books, supplies, and tools) are qualified uses of 529 plan withdrawals.
Unused funds in a 529 plan are surprisingly flexible and there is no federal time limit to use 529 assets. You can keep them for later education needs, shift funds to a new beneficiary, and starting in 2024 you can roll up to $35,000 (lifetime limit) into the beneficiary’s Roth IRA.
Coverdell ESA
Another popular tax-advantaged investment account that is designed to facilitate saving for a child’s education is a Coverdell Education Savings Account (ESA). Similar to 529 plans, the Coverdell ESA offers tax-free withdrawls on earnings and contributions for qualified educational expenses. A Coverdell ESA can be opened for anyone age 18 or younger and the beneficiary may be changed to a family member of the original beneficiary.
Contribution Flexibility
One drawback to the Coverdell ESA is they have certain eligibility restrictions and lower maximum contribution limits than alternatives. Only single filers earning less than $110,000 or joint-filers earning less than $220,000 can contribute to this type of account. The maximum contribution per beneficiary per year is $2,000 combined from all sources. Which means if you contribute $1,000 in a year to your child’s Coverdell ESA and they have grandparents that also want to make a contribution, the grandparents are limited to only contributing $1,000 in the same year. Contributions can also only be made until the beneficiary turns 18.
The income restriction and contribution limit are key considerations in choosing this savings tool. If you open a Coverdell ESA and later exceed the income limit you cannot contribute to the account without incurring a penalty. Given the annual $2,000 contribution limit, this option may not cover the total cost of education.
Investment Options
The main advantage to the Coverdell ESA is the investment flexibility. Account holders have a broad range of investment options and control over the account, including the ability to self-direct the investment choices. You can tailor the investment strategy to your specific financial goals and risk tolerance by utilizing mutual funds, ETFs, stocks, and bonds.
If you choose to self-direct the account, the investment choices are even more flexible. Using a Self-Directed Coverdell ESA, you can invest in precious metals, real estate, cryptocurrencies, private placements, and businesses. The range of alternative assets this account type can invest in make it one of the major advantages it offers.
Withdrawals
Like the 529 plan, withdrawals used for qualified educational expenses are tax-free and the earnings portion of a non-qualified withdrawal is taxed as ordinary income plus a 10% penalty. One major difference that makes the Coverdell ESA more flexible than a 529 plan is the Coverdell may be used for more than just K-12 tuition. Items such as book and supplies, tutoring, room and board are qualified expenses whereas the 529 plan only includes K-12 tuition as a qualified expense.
Unused funds from the Coverdell ESA must be fully withdrawn by the time the beneficiary reaches age 30. However, the account can be rolled over to certain family members of the original beneficiary which is why it is one of the more popular college savings strategies.
Custodial Account (UGMA/UTMA)
UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfers to Minors Act) accounts are custodial accounts which enable an adult to hold and manage assets for a minor until the child reaches adulthood. UGMA accounts are available in all 50 states however UTMA accounts (only unavailable in South Carolina and Vermont) are more widely used due to their broader asset flexibility. Typically these accounts help supplement flexible gifting rather than being utilized as one of the core college savings strategies.
Contribution Flexibility
UGMA/UTMA custodial accounts are quite flexible as they do not have contribution limits. These accounts effectively serve as a trust but are easier to open without a lawyer and often cost less than establishing a trust. This means the assets are the legal property of the beneficiary and are protected beyond the reach of any third-party events like bankruptcy or other family members. However, once you deposit funds into the account the transfer is irrevocable and you cannot access or withdraw the money even if you need it like in the case of medical emergencies or job loss.
Investment Options
UGMA/UTMA accounts differ in what types of assets they can hold. UGMA accounts (less common) are limited to holding financial assets such as cash, stocks, bonds, and mutual funds. UTMA accounts are more flexible and can hold financial assets as well as physical assets like real estate, precious metals, real property, and even intellectual property. This flexibility makes the transfer of non-financial assets possible because the trust structure allows for binding contracts on the child’s behalf.
UGMA/UTMA accounts are not as tax-advantaged as 529 plans or the Coverdell ESA. All dividends, interest, and capital gains are taxable in the year they are earned but they do have some favorable tax treatment. Earnings are typically taxed at the child’s lower income tax rate up to a certain point – as of 2025, the first $1,350 of a child’s unearned income is tax-free, the next $1,350 is taxed at the child’s rate, and unearned income above $2,700 is taxed at the parent’s marginal rate. This is commonly referred to as the “kiddie tax.”
Withdrawals
These accounts are extremely flexible and may be used by the custodian to cover expenses beyond tuition like extracurricular activities, sports, camps, instruments – as long as the expense is only for the benefit of the minor and it is consistent with the custodian’s fiduciary duty.
Once the beneficiary reaches the age of majority (age 21 in Alabama) all remaining funds become theirs free and clear of any conditions. The custodian cannot specify a purpose for the funds once the recipient comes of age and they can use the money however they would like. One of the main functions of these accounts is to ensure the account remains solvent until the recipient reaches adulthood. The trust structure prevents careless spending or adults taking advantage of a child.
Key Insights
529 plans form the core of most college savings strategies due to their accessibility and permanent tax benefits. Coverdell ESAs suit income-eligible families seeking investment flexibility. UGMA/UTMA custodial accounts provide non-college expense flexibility.
In Part 2, discover flexible savings supplements, what to do if college isn’t in the cards, and how your savings strategy affects financial aid.