A college education is often the third biggest financial
goal for a family, behind only buying a house and retirement. Frequently,
parents try to set money aside for this major goal soon after a
child is born. Here are two tax-favored federal- and state-sponsored
savings plans that can make it easier to attain that goal.
Coverdell education savings
This is a federally sponsored plan that allows you
to set aside money for higher education expenses, including tuition,
fees, books, supplies and, sometimes, room and board.
Annual contributions are limited
and they are not tax-deductible, but the contributions and their
earnings can be withdrawn tax-free, as long as they're used to pay
for eligible education costs.
A Coverdell is a custodial account set up usually
by a parent or other adult to pay the education expenses of a designated
beneficiary. The child must be under the age of 18 when the account
is established, and Coverdell balances must be spent within 30 days
after he or she reaches age 30.
You can set up a Coverdell at any financial institution
(a bank, investment company, brokerage, etc.) that handles traditional
IRAs. You can put your contributions into any qualifying investment
vehicle -- stocks, bonds, mutual funds, certificates of deposit
-- offered at the institution that will serve as the account's custodian.
There is no limit on the number of Coverdell accounts
that you can establish for a child. In other words, you could have
one account at a brokerage and one at a bank. Be aware that some
529 plans are riddled with fees.
Be sure that management fees for multiple accounts don't eat into
your overall return.
What happens if Junior decides that college is not
really for him? He'll have to pay when he turns 30. He must take
any balance in the account within 30 days of his birthday, pay tax
on the earnings plus a 10 percent Internal Revenue Service penalty.
The IRS, however, offers a way out of this taxable
situation. Junior can roll over the full balance to another Coverdell
plan for another family member. This could be a younger sibling,
niece, nephew or even his own son or daughter.
529 college savings plans
State-sponsored 529 plans are named after the section
of the federal tax code that allows them. All 50 states and the
District of Columbia now have 529 plans available.
Contributions to a plan are not deductible, but the
contributions and their earnings can be withdrawn tax-free when
used for qualified education expenses.
There are two basic types of 529 plans: prepaid tuition
and savings/investment plans.
A prepaid tuition plan lets you purchase units
of tuition for any state college or university at today's prices.
In other words, a semester's worth of prepaid tuition purchased
today will pay for a semester's worth of tuition at any future date.
A student could choose to apply tuition purchased
in a prepaid program to a private or out-of-state college, but the
family may have to scramble to pay additional tuition costs. For
example, two year's worth of tuition at a state university purchased
today might only pay a single semester of tuition at a private college
To participate in a state's prepaid tuition program,
either the contributor, typically a parent or grandparent, or the
beneficiary, the future student, must be a resident of the state.