Taking Advantage of Government-Sponsored Savings Plans
If you have 18 years to save for college, chances are you'll end up with quite a bit of money for your child. But even if you don't have that much time, three tax-free college-savings vehicles can help you save for your child's college expenses.
Between the grants that are available to students and the tax savings you can realize, the government can actually be a big help to you and your child. On average, students receive more than $3,000 in grants and tax benefits at public four-year colleges; $9,000 per year at private four-year schools; and $2,200 per year (or nearly the entire amount of tuition) at two-year colleges.
Coverdell Education Savings Accounts
Although renamed the Coverdell education savings accounts several years ago, these are still often called by their old name: Education IRAs. These accounts allow you to contribute $2,000 per year, tax free, for college. The withdrawals are tax free, too.
The account is in the name of the child (called the beneficiary), and nearly anyone can contribute to it tax free, including grandparents, godparents, aunts and uncles, and you, up to the maximum amount each year. Contributing more than the maximum amount, even from several different sources, can result in penalties.
The tax savings for contributing to Coverdell accounts begins to phase out at $95,000 in income for individuals and $190,000 for couples. That's a lot of income, yes, and probably doesn't apply to you, but if other family members or friends want to contribute to your child's IRA, they should be aware that there are income limits on who can receive the tax break.
The money in Coverdell accounts can be used not only for college tuition, fees, room, board, and books, but also for an education-related computer, academic tutoring, and transportation to and from school. The money can also be used for K-12 expenses, including private-school tuition.
If the funds aren't used for education, the account remains in the name of the beneficiary — it doesn't revert back to you or the other donors, and this might really grind your gears.
There's only one catch, really: The funds must be used within a month of your child turning 30 years old. If money were ever left in a Coverdell account and your child turned 30 plus a month, he or she could start another account in the name of another child. This does mean, however, that Coverdell accounts aren't very useful for older adults who want to return to college.
Okay, there's kind of another catch, too. The financial institution that holds your Coverdell account will charge the account a maintenance fee for managing the investment account. The fee is usually small, however.
529s: College Savings Plans
All U.S. states currently sponsor college-savings investment plans. Currently, money put into a state-sponsored 529 is tax free upon withdrawal, and some states give a tax break when you contribute to the plan, too. Beginning in 2010, however, withdrawals will be taxed at the child's current tax rate.
How can I get information about my state's plan?
The Saving for College website lists every 529 savings plan administered in the country, and then reviews information about the plan's manager and its investment rating.
The fact that states sponsor the plans (and may give state income-tax breaks on the deposits) leads some people to believe that your child has to attend an in-state public university in order to use the funds. Only state-sponsored prepaid-tuition plans have that requirement; funds in 529 college-savings plans can be used at any college or university in the country.
Basically, the plans operate very much like an education IRA, except that instead of the money being owned and controlled by the child, 529s are owned and controlled by the parent. Your child is still the named beneficiary, but he or she has no legal right to the money if you choose not to authorize a withdrawal. And you can change the named beneficiary at any time. Anyone can contribute to the 529 fund.
Another striking difference between an education IRA and a 529 is that the amount you can contribute to a 529 is virtually limitless, with no loss of tax benefits for high-income donors. Also, the plan doesn't stop at age 30, so you can establish one for yourself to earn your first degree or attend graduate school.
The tax implications of 529s are not easy to understand. If you're already using the services of a tax accountant, be sure to discuss your college-savings plan, too. If not, consider hiring a qualified tax accountant to help you wade through the many regulations covering these plans.
The account is placed in the hands of an investment-fund manager who charges a maintenance fee, and you can establish direct-deposit funds into the account, making deposits to the plan simple and relatively painless.
Another Kind of 529: Prepaid Tuition Plans
A prepaid-tuition plan allows you to buy tuition shares or units and then hold on to those shares until your child wants to use them. Buying a share is just like paying tuition, but at today's prices. You lock in at today's tuition rates, thus avoiding the dreaded annual increase in tuition.
Family members and friends can buy shares for your child, too, but some states require contracts that lock you in to buying a certain number of shares in a given period of time.
When your child receives the prepaid-tuition shares to use to pay for college, the federal government usually taxes them as income. Since your child has a low tax rate, it may still result in tax savings. States don't usually tax prepaid-tuition shares.
The plans vary greatly in where and how they can be used. Some colleges and universities sell tuition shares directly, but they can be used only at that school.
In other cases, states sell the shares, and they can be used at any public — and sometimes private — college in that state. Some blocks of schools (like a group of private schools) sell the share.
If your child decides not to attend that college or isn't accepted at one, you may be eligible for a refund of the tuition shares, but often a penalty is levied. If you purchased the shares directly from the college or university, you may be able to sell them to another family to use.