The third biggest financial goal for a family is saving for a college education. Buying a house and retirement are the first two goals. With the cost of higher education on the rise, parents are beginning to try and set aside money for education as soon as a child is born. There are two popular federal and state sponsored plans that make saving for college easy: the Coverdell and the 529 plan.
The Coverdell Education Savings Account
The Coverdell is a federally sponsored plan that helps you to set aside money for higher education expenses. These expenses include tuition, fees, books and supplies, and even room and board.
The annual contributions are not tax deductible, making the withdrawals tax-free as long as they are used to pay for eligible education costs. There are limits to the amount of annual contributions that can be made each year.
The Coverdell is established as a custodial account, set up by the parent or another adult to pay for the education expenses of a designated beneficiary. The child must be under the age of 18 to establish an account. All balances must be spent within 30 days of the child’s 30th birthday.
Any financial institution that handles IRAs can assist you in setting up a Coverdell, including banks, investment companies and brokerages. The Coverdell is like an IRA in that it is an account. You can put your account funds into any investment you want – stocks, bonds, mutual funds and certificates of deposit are just a few options.
You can establish as many Coverdell accounts as you want to for a child. For example, you could have one account at your local bank and one at a brokerage. Some plans have many fees associated with them. Make sure that the management fees for the multiple accounts don’t cancel out your overall return.
If your child decides not to go to college, he or she will lose a great deal of money. When he turns 30, he must withdraw the balance of the account within 30 days. Any money withdrawn that isn’t used for educationally eligible expenses is taxed and charged a 10 % IRS penalty.
If your child decides not to go to college, that doesn’t mean that his or her child won’t. The child can roll the full balance into another Coverdell plan for another family member, including siblings, nieces and nephews and sons and daughters.
529 College Savings Plans
These state sponsored 529 plans are named after the federal tax code section that provides for their use. All 50 states and the District of Columbia offer 529 plans. The contributions to the plan are not tax deductible, but your withdrawals are tax-free when you use the money for a qualified educational expense.
529 plans fall under two categories: prepaid tuition and savings/investment plans.
The prepaid tuition plan allows you to purchase units of tuition for any state college or university under today’s price. You are buying a semester of attendance for a child. What you buy today will be good for any future date, no matter how tuition rates rise. With private and out-of-state colleges, the child’s prepaid tuition does not include the rise in tuition costs. For example, if you buy two years of college tuition for an out-of-state tuition, you may only receive a single semester in ten years.
Either the beneficiary or the contributor must reside in the state that the 529 is formed in.
With savings plans, an account is opened and investments are chosen within the account. If you start the plan when a child is young, you can choose some aggressive investments for long term growth. As the child ages, you can move your investments into more conservative options.
The withdrawals are tax-free if they are used to pay for college expenses. These expenses can include tuition, books and room and board. An easy way to think about a 529 savings plan is as a 401(k) dedicated to educational expenses. As with a 401(k), there are many different investment choices. Many states programs are open to nonresidents, so look around for the best plans.
If your child decides not to go to college you have three options. You can hang on to the savings plan in case your child decides to attend college at a later date. The account can be transferred to another family member for college expenses. You could also cash out the account and just take the loss. Most states will charge a penalty of 10% of the earnings for any withdrawal not used for education. On top of this, a federal penalty of 10% will be charged also. There is no penalty for withdrawals due to death or disabled status.
The tax-free advantages of a college savings plan makes 529 plans beneficial, but they aren’t right for everyone. If you have a 529 prepaid tuition plan, applying for financial aid is affected by reducing your financial aid on a dollar per dollar basis. Low income families, who are often eligible for large amounts of financial aid, are advised not to participate in 529 plans.
Coverdell plans will also decrease the amount of financial aid available, but only by about 5 to 6% of the account’s value. College savings plans are great for families that will not qualify for financial aid or only qualify for loans. Many times a family doesn’t have enough money to pay for college, but has too much money to get help.
The tax-free status on 529 plans will end in 2010, but many advisors expect that Congress will extend it.