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 account

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Annual contributions are limited and they are not tax-deductible, but the contributions and their earnings can be withdrawn tax-free, as long as they’re used to pay for eligible education costs.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Contributions to a plan are not deductible, but the contributions and their earnings can be withdrawn tax-free when used for qualified education expenses.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 in 2011.

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.

— Updated: Oct 19, 2006

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 a son’s or daughter’s college expenses including tuition, books and room and board. It’s essentially a 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 three basic choices: hang on to the savings plan, transfer it to another family member or cash out and pay a penalty.

Some parents hang on to the 529 plan in case the child decides to attend college at a later date. Others transfer the account over to another family member.

Some parents decide to cash out the plan and pay a penalty. Most states collect a penalty of 10 percent of the earnings on any withdrawal that is used for noneducational purposes.

A federal penalty equal to 10 percent 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. Participating in a 529 prepaid tuition plan affects a family’s eligibility for financial aid. It’s considered a resource for the student like a scholarship. It reduces financial aid on a dollar-per-dollar basis.

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.

College savings at a glance
Coverdell education

savings account

529 college savings plans
  • Federally sponsored
  • Limit to annual contributions
  • Contributions are not tax-deductible
  • Tax-free withdrawals for qualified education expenses
  • Contributions may be placed into any qualifying investment vehicle
  • No limit on number of Coverdell rollover options available or incur a taxable situation with penalty
  • State sponsored
  • Not tax deductible
  • Tax-free withdrawals for qualified education expenses
  • Two types: prepaid tuition and savings plan eligibility for financial aid
  • Each savings program offers investment choices
  • If not used: options to hold a savings plan, transfer plan to a family member or cash out and pay a penalty.

Participating in a college savings plan also impacts financial aid, but not as severely. A family with a college savings account will see their eligibility for aid decrease by as much as 5 percent or 6 percent of the account’s value.

College savings plans may make the most sense for upper income families who won’t qualify for financial aid and for middle-income families who qualify for loans and little else.

State-by-state program listing

A state-by-state listing of programs is available on the Web site of the College Savings Plans Network and on Savingforcollege.com.

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