taxes

10 ways Uncle Sam helps you save money

College savings plans

These savings vehicles, named after Section 529 of the Internal Revenue Code and known collectively as 529 or qualified tuition plans, come in two flavors: prepaid tuition plans and college savings plans. All 50 states and the District of Columbia sponsor at least one type of these plans.

8. Prepaid tuition plans

With a prepaid tuition plan, you can pay for attendance at participating public colleges and universities in advance, generally many years before the student actually enrolls.

  • Advantages: Prepaid plans allow you to buy a future education at today's cost -- a sizable expected savings given the rate of increase over recent years. The plans usually are guaranteed or backed by the state.
  • Drawbacks: Since many prepaid tuition plans are under the aegis of state governments, they generally have residency requirements, meaning your college choices could be limited. The plans also have age and grade limits for the beneficiary student. In most cases, only tuition and mandatory fees are covered in prepaid plans.

9. College savings plans

With a college savings plan, you establish an account to pay for a student's future college expenses.

  • Advantages: Withdrawals from college savings plans can generally be used at any college or university, regardless of its location. Distributions for eligible college costs are tax-free. Savings plans will cover a wider range of expenses than prepaid tuition programs; this includes room, board and books in addition to tuition and fees.
  • Drawbacks: As with any investment, risk is a factor; the plan money is not guaranteed by the associated state government and is not federally insured. If you use account money for ineligible expenses, you'll owe federal taxes on the amount as well as an additional 10 percent penalty on earnings. Savings in a 529 plan could reduce a student's eligibility for other financial aid. Pay close attention to the plans fees, which could take a substantial cut of its earnings.

10. Savings bonds

This savings vehicle is often viewed as old-fashioned, but today's savings bonds are not the bonds your grandparents or even your parents bought. Enhancements to these federally backed instruments make them attractive to many looking for an easy, safe and, in some instances, quite competitive way to sock away cash. The most popular savings bonds are Series EE, the fixed-rate variety, and Series I, which is indexed periodically to inflation.

  • Advantages: The purchase price of a Series EE bond is just half its eventual maturity value. Both EE and I bonds come in eight denominations, ranging from $50 to $10,000. You can buy bonds directly from the U.S. Treasury at the department's TreasuryDirect Web site. Interest earned is exempt from state or local taxation. Federal taxes are deferred until you cash the bond, but if you redeem them to pay for higher-education expenses, you might be able to also avoid federal taxes on the earnings.
  • Drawbacks: Unless the bonds are used for college costs, you'll eventually owe the IRS for the accrued earnings. The Series I bond does not offer a half-price purchase option. You must hold both types of bonds for at least one year before you can redeem them. Both series charge a three-month interest penalty if you redeem the bonds during the first five years. You need to pay attention to when you cash in the bonds, because the redemption timing affects the amount of interest you'll get.

Don't try this at work

There's one more tax-related savings option that many people use, but it's not recommended by most financial advisers: paycheck overwithholding.

Many employees intentionally have an excess amount of federal taxes withheld from their pay so that they'll get a fat refund at tax time. But if you adjust your withholding so that it more accurately matches your ultimate tax bill, you'll have immediate use of your cash. That way, you can put it into a savings account where it can earn more for you, instead of letting Uncle Sam have your money for most of the year as an interest-free loan.

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