Saving for college: A look at federal and state-sponsored plans

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A college education often is the third biggest financial goal for a family, only behind buying a house and retirement. Frequently, parents try to set money aside for this major goal soon after a child is born. Here are 2 tax-favored federal and state-sponsored savings plans that can make it easier to attain that goal.

1. Coverdell education savings account

This is a federally sponsored plan that allows you to set aside money for higher education expenses, including:

  • Tuition
  • Fees
  • Books
  • Supplies
  • Room and board (sometimes)

Annual contributions are limited and they are not tax-deductible, but the contributions and their earnings can be withdrawn tax-free, as long as they're used to pay for eligible education costs.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.

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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.

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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 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 and pay tax on the earnings plus a 10% IRS 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.

2. 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 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 2 basic types of 529 plans:

  1. Prepaid tuition
  2. 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, 2 years of tuition at a state university purchased today might only pay a single semester of tuition at a private college in several years.

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.

With a savings plan, parents open an account and choose an investment strategy. Typically, if you start the plan when the child is very young, you'd begin with some aggressive investments and gradually switch to more conservative options as the child grows.

Withdrawals are tax-free when it's time to pay for college expenses including tuition, books and room and board. It's essentially a Roth 401(k) dedicated to paying for college expenses.

Each savings program offers parents several different investment choices. Many state programs are open to nonresidents, so it makes sense for parents to shop around for a plan that best meets their financial and educational needs.

What happens if the child decides not to go to college?

A parent has 3 basic choices:

  1. Hang on to the savings plan.
  2. Transfer it to another family member.
  3. Cash out and pay a penalty.

Most states collect a penalty of 10% of the earnings on any withdrawal that is used for noneducational purposes.

A federal penalty equal to 10% of earnings will be charged, as well. No penalty will be assessed if a beneficiary should die or become disabled.

While the tax-free withdrawals clearly make 529 plans attractive financial options, they may not be right for every family.

Some financial advisers urge lower-income families, who are likely to receive a large amount of financial aid, to pass on 529 prepaid tuition plans.

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