There are two common products:
Coverdell ESA
Formally known as Education IRA. In 2002, however, the re-named Coverdell education savings account became a very attractive college savings vehicle for many people, including families that wish to save for elementary and secondary school expenses as certain K-12 expenses were added to the list of qualified expenses. In fact, even if you like the 529 plan you may still decide to contribute the first $2,000 of savings for each child into a Coverdell account. There are some items to be aware of, however, such as the following:
- There are certain eligibility requirements in the year you wish to contribute to the ESA, which means that not everyone will find them useful. For example, tax law prohibits ESA funding once the beneficiary reaches age 18.
- In 2002, the contribution limit was increased from $500 per child to the much more reasonable level of $2,000. However, you need to be careful when accounts are established by different family members for the same child. If total contributions exceed $2,000 in a year, a penalty will be owed.
- The relatively low contribution limit means that even a small annual maintenance fee charged by the financial institution holding your ESA could significantly affect your overall investment return.
- Your contribution goes into an account that will eventually be distributed to your child if not used for college. You cannot simply refund the account back to yourself like you can with most 529 plans. This means you lose some degree of control.
- The ESA is on equal footing with the 529 plan when applying for federal financial aid. The account is considered an asset of the account custodian, typically the parent. Withdrawals are not reported as student or parent income as long as it is tax-free for federal income taxes.
- Coordinating withdrawals with other tax benefits, especially the Hope or Lifetime Learning credits, can be tricky.
- The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties.
- Unless Congress acts (again), certain ESA benefits expire after 2012. K -12 expenses will no longer qualify, the annual contribution limit will be reduced to $500, and withdrawals will not be tax-free in any year in which a Hope credit or Lifetime credit or Lifetime Learning credit is claimed for the beneficiary.
529 Savings Plan
A 529 Plan is an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Code which created these types of savings plans in 1996.
State Plans Are OK For Out Of State Colleges
529 Plans can be used to meet costs of qualified colleges nationwide. In most plans, your choice of school is not affected by the state your 529 savings plan is from. You can be a CA resident, invest in a VT plan and send your student to college in NC. Check to see if your institution is eligible under 529 rules.
Which States Offer 529 Plans?
Every state now has at least one 529 plan available. It’s up to each state to decide whether it will offer a 529 plan (possibly more than one) and what it will look like, meaning 529 plans can differ from state to state. You should research the features and benefits of your plan before you invest, research state 529 plans and even compare between plans.
Tax Benefits
As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to you, the plan participant. See the top 7 benefits of 529 plans.
Some states (but not all) offer tax incentives to investors as well. Research your state’s tax treatment.
Types Of 529 Plans
529 plans are usually categorized as either prepaid or savings plans.
Savings Plans work much like a 401K or IRA by investing your contributions in mutual funds or similar investments. The plan will offer you several investment options from which to choose. Your account will go up or down in value based on the performance of the particular option you select.
Prepaid Plans let you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Independent 529 Plan is a separate prepaid plan for private colleges.
Educational institutions can offer a 529 prepaid plan but not a 529 savings plan (the private-college Independent 529 Plan is the only institution-sponsored 529 plan thus far).
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