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Annual contributions are limited and they are not tax-deductible, but the contributions and their earnings can be withdrawn tax-free, as long as they're used to pay for eligible education costs.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Contributions to a plan are not deductible, but the contributions and their earnings can be withdrawn tax-free when used for qualified education expenses.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