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Financial Literacy - College funding
Paying for college: the savings route
What's the best way to save? This highlights the pros and cons of 529 plans, Coverdells, custodial accounts and bonds.
Smart ways to pay for college

Which college savings plan is right for you?

If you're contemplating an education savings plan but are confused about which is best for you, click on the different plans to discover the advantages and drawbacks of each.

4 plans for financing education
529 plans
Savings bonds
Custodial accounts
Overview: Categorized as either prepaid or savings, 529 plans are available in every state. The donor stays in control of the funds (with few exceptions) and determines when the beneficiary receives the money.

Pros: Earnings grow tax deferred, and withdrawals are tax-free as long as the money is used for higher education. You can contribute substantial amounts to the 529 plan, more than $230,000 per beneficiary in many states. There is no income limit for contributors.

Contributions qualify for the annual gift tax exclusion of $12,000 per person. However, you can donate up to $60,000 in a single year and elect to treat it as if it were made over five years for gift-tax purposes. This gives some donors the ability to remove assets from their estate while still maintaining control over the contribution.

Plan assets are managed by the state treasurer's office or an outside investment company. You can change the investment every year or roll it over to a different state's program. If the account has grown beyond what's needed or the original beneficiary has decided not to go to college, it can be transferred to another qualifying beneficiary at any time.

Cons: There is a 10 percent penalty and taxes on earnings for nonqualified distributions.

Overview: Previously named education IRAs, Coverdell education savings accounts are set up and managed at any financial institution that handles IRAs. Contributions can be placed among qualified investment vehicles offered at the institution.

Pros: Coverdell can be used for all levels of education, not just college, and you have the ability to pay for more types of education expenses with the money. The account can be combined with other education tax breaks. Earnings grow tax deferred, and withdrawals are tax-free if they do not exceed the beneficiary's qualified education expenses for the tax year. The IRS allows a beneficiary to roll over the balance to another Coverdell plan for a family member.

Cons: Contributions are capped at $2,000 per year, and there are income limits: $95,000 for single taxpayers and $190,000 for married filing jointly. Single taxpayers making up to $110,000 and married couples earning up to $220,000 are allowed to make smaller contributions.

Contributions are not tax-free. If an amount more than $2,000 is contributed in a single year, there is a 6 percent annual excess contribution tax. The money must be used for education, and if it is not, the beneficiary has to withdraw any balance in the account within 30 days of his or her 30th birthday and pay tax on the earnings and a 10 percent penalty.

Overview: The Education Bond Program created by the Treasury Department in 1990 encompasses EE bonds and Series I bonds. Denominations from $50 to $10,000 are available. Bonds are in the name of the purchaser, who must be at least 24 years old.

Pros: There is no penalty if the money is not used for education, and no federal income tax on interest earned if the money is applied toward tuition and fees.

Cons: Bonds have to be spent in the year they are redeemed. There is no tax on earnings if they are applied to qualified education expenses, but income guidelines must be met to benefit from the exemption. In 2007 the exemption begins to phase out when joint adjusted gross income, or AGI, is $98,400, or $65,600 for a single taxpayer. It disappears completely when joint AGI is $128,400 or $80,600 single.

If you redeem more than you spend on qualified education expenses, the remainder will be taxed on a pro-rata basis. For example, if you have $6,000 in qualified expenses but have cashed a $10,000 bond consisting of $8,000 principal and $2,000 interest, you will exclude 60 percent of the earned interest, or $1,200. The remaining $800 interest will be taxable.

Overview: Also known as Uniform Transfer to Minors Act, or UTMA, and Uniform Gifts to Minors Act, or UGMA, these are typically used by families with income too high to receive financial aid.

Pros: There are no limits on annual contributions, and any family member can contribute. Earnings up to $850 per year will be tax-free. Withdrawals are allowed at any time without penalties.

Cons: Considered income-producing assets of the minor, these accounts can significantly impact the receipt of financial aid

The account cannot be transferred to another beneficiary. They are set up in the name of the parent or custodian, but the child will take over the account at age 18 and doesn't have to use the money for education.

-- Posted: Sept. 17, 2007
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