If you’re like most Americans with school-age children or grandchildren, you may be wondering how you can ever save enough money to send them to college. Every year you hear that college costs are rising more than inflation and that, 18 years from now, it will cost a lot more to send your child to state or private colleges.
These facts are humbling, but there is some good news to report. In spring 2001, Congress revamped education savings programs to improve and expand their tax benefits. These changes took effect in 2002. Two of the enhanced programs are 529 plans and Coverdell Education Savings Accounts (formerly Education IRAs).
Even if you can’t save a lot, you can still take advantage of these enhanced programs by starting early. The power of tax-free investments compounding over 18 or so years may surprise you. If you are able to save a third or even half of the total cost, that will be a big help.
With this in mind, it is time to take a close look at the current college savings programs. You and your financial adviser will decide which plan works best for you when you look at the comparisons and descriptions.
Tax-advantaged ways to save for college
Two tax-advantaged ways of saving for college are Section 529 savings plans and Coverdell Education Savings Accounts. Many investors have also used custodial accounts such as those authorized under state-sponsored Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Each of these has benefits and limitations.
Named after Section 529 of the Internal Revenue Code, these plans are generally sponsored by individual states. Assets in the plans are professionally managed by independent investment firms or state government agencies. All states have 529 plans now or soon plan to offer one. Most 529 plans offer a number of benefits: Savings and earnings grow tax-free and you pay no federal income taxes when the money is withdrawn to pay for qualified higher education expenses.*
- Withdrawals for something other than qualified higher education expenses are subject to federal income tax and may face a 10% federal tax penalty on earnings.
- Investing in a 529 plan may impact the beneficiary's ability to qualify for grants and student loans.
- Some states offer residents an incentive to invest in their state-sponsored 529 college savings plans. Be sure to ask your tax adviser.
- Investors should carefully consider the investment objectives, risks, charges and expenses of a particular 529 plan. This and other important information is contained in the offering statements, which can be obtained from your financial adviser and should be read carefully before investing.
- There may be income and contribution limits
Coverdell Education Savings Accounts
The accounts have been offering tax-free withdrawals for higher education since 1998. Coverdell accounts — unlike 529 plans — can be used for elementary and secondary education and even for academic tutoring and education-related computer expenses. The payoff for investing in Coverdell accounts could be substantial.
Can I invest in both a 529 plan and other education savings accounts?
Yes, investments in a 529 plan will not affect your ability to invest in a Coverdell Education Savings Account for the same beneficiary. Investing in both can be an especially good idea because the two complement one another.
Are UGMAs and UTMAs — custodial accounts in the child’s name — still valid choices?
For many years, these accounts were the only substantial education savings vehicles available, so many investors have built up sizable amounts in custodial accounts. Unlike Coverdell accounts, there are no income or contribution limits for contributors. At least part of the earnings on the investment may be exempt from federal income tax, and some or all will be taxed at the child’s lower rate up to a certain age. Money can be withdrawn anytime for the benefit of the child — not just for education.