The good news when it comes to saving for your children's college education is that there are more options available to help than ever before. Following is a detailed look at the most popular education savings vehicles available to families today:
- Section 529 College Savings Plans are operated by states or educational institutions and come in two forms:
- Prepaid tuition plans–These lock in today's tuition costs for a future student, avoiding tuition increases that could come later. As long as the money stays in the plan, earnings accumulate on a tax-deferred basis, and distributions for tuition and other qualified expenses are federally tax-free.
- Investment savings plans–Similar to retirement savings plans like IRAs, these plans seek to provide several investment options for your account. These choices allow you to select the appropriate level of risk and potential return for your investment.
529 plans allow tax-deferred growth and tax-free distributions if funds are used for qualified education expenses. There are no income or age restrictions, and large amounts (as much as $300,000)* can be contributed over time on behalf of each child.
It's important to note that the money in a Section 529 plan must be used for educational purposes. Otherwise, upon withdrawal, earnings (but not contributions) are subject to taxes and a 10 percent penalty. Funds can be transferred from one child to another, which provides some flexibility if a child should decide not to go to college.
Coverdell Education Savings Accounts (ESAs) can be used to save for private elementary and secondary school expenses, as well as college savings. The annual contribution limit for ESAs is $2,000**, making them a more viable education savings tool.
Any family member or friend can contribute to a Coverdell ESA on behalf of your child. Contributions (nondeductible) are made to a specially designated investment trust account where, like those to Section 529 plans, they grow tax-deferred and can be withdrawn federally tax-free if used for qualified education expenses.
Unlike 529 plans, however, the money doesn't have to be used for qualified educational expenses–it will eventually be distributed (with some portion taxed) to your child if he or she doesn't attend college, or receives scholarships and/or financial aid and doesn't need the money for qualified education expenses.
Coverdell ESA funds can be transferred from one child to another, which gives these accounts an added degree of flexibility. Keep in mind, however, that if the account is not fully withdrawn by the time the beneficiary reaches age 30, it will be subject to taxes and penalties. Contributions can no longer be made to the account once the beneficiary reaches age 18.
Many families use Coverdell ESAs in conjunction with Section 529 plans, contributing the first $2,000 each year to a Coverdell. Also, funds can be transferred from Coverdell ESAs to 529 plans.
Custodial Accounts, also known as UGMAs and UTMAs (these acronyms stand for Uniform Gifts to Minors Act and Uniform Transfers to Minors Act), are special accounts set up by parents and grandparents for the exclusive benefit of their children and grandchildren.
While custodial accounts don't offer tax-free growth and distributions like 529s and Coverdell ESAs, they do offer another tax benefit: Most of the earnings are taxed at the child's rate, which is usually lower than the parents' or grandparents'. There are no annual contribution limits, although contributions above $14,000 a year (or $28,000 if married filing jointly) to a child's custodial account may be subject to federal gift taxes.
A potential drawback to custodial accounts is the fact that the child will assume complete control of the funds when he or she reaches age 18 or 21 (depending on the state), and the money doesn't have to be used for college. However, this flexibility could be a benefit if you and your child together decide against going to college, or the child receives scholarships and/or financial aid and doesn't need the money for college.
Roth Individual Retirement Accounts (IRAs) are usually thought of as retirement savings tools, however, many families use them as potential college savings vehicles as well. Their flexibility makes them a great option for killing two birds–both retirement and college–with one investing stone.
Here's why: Contributions to Roth IRAs can be withdrawn prior to age 59½ for any purpose you choose without tax or penalty. This includes paying for private school, college or any other form of higher education. With this strategy, you could withdraw some or all of your Roth IRA principal for college and leave the earnings in the account for retirement.
With a Roth IRA, you receive no deduction for contributions, but all earnings are tax-free upon withdrawal. So you save money on an after-tax basis with tax-deferred accumulation of earnings and tax-free withdrawals. In 2013, you and your spouse can each contribute up to $5,500 (or $6,500 if you're age 50 or over) to separate Roth IRAs for yourselves.
*Contribution limits may vary by plan.
**Contribution limits are based upon modified adjusted gross income and are phased out for certain high income contributors.