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If you want to give your kids a head start in saving for college, there are a variety of ways to do so. For example, you can open a savings account or begin investing money into stocks. Both can be done in your name or your child’s name.
Another option is to choose a tax-advantaged plan, which can often help you accumulate savings faster. These plans include any type of investment, account or plan that is either exempt from taxation, tax-deferred or offers other types of tax benefits.
The two most popular tax-advantaged college savings plans are Qualified Tuition Programs, commonly known as QTPs or 529 plans, and the Coverdell Education Savings Account.
How the plans work
With the Coverdell ESA, money is deposited into the account while you are saving for college, and then later withdrawn for education expenses.
In the case of a 529 plan, you can choose from two options. The first option allows you to put money into the fund and later withdraw the money for education expenses, just like you would with an ESA. The second option is to open a prepaid 529 plan, which allows you to save education credits to be used when the time comes for college.
Contributions to both plans are nondeductible
Unfortunately, you can’t deduct contributions made to either type of college savings plan.
So, when does the tax advantage kick in? Once you need to make a payment for tuition and fees, you don’t have to pay tax on the withdrawals. This also applies to any interest or other earnings in the account if you use the withdrawals for qualified educational expenses.
The same goes for prepaid 529 plans, any education credits used for education expenses are tax exempt.
Who owns and controls the plan?
With a 529 plan, the account must be in your name, not your child’s. This gives you more control and flexibility. You also don’t have to specify which child the account will be used for. And, if you have a family emergency, you have access to the funds if you need them.
The opposite is true for Coverdell ESAs. The account must be in the name of the designated beneficiary, not yours. However, that doesn’t mean you’re out of luck if plans change.
For example, if the designated beneficiary decides not to go to college, and your other child has her eye on medical school, you can choose to change beneficiaries without a tax penalty.
The only requirement is the new beneficiary must be a member of the beneficiary’s family.
What are the contribution limits?
One disadvantage of ESA plans is that you and any other contributors, such as grandparents, can only invest $2,000 per year for each child. Due to that restriction, ESAs aren’t the best route if you’re getting a late start in saving for college costs.
On the other hand, 529 plan contribution limits are determined by the state in which the account is held. The limits do vary, but typically you can contribute as much as you want to the plan.
Watch out for income limitations
Any contributions to or withdrawals from a 529 plan are not restricted based on income level.
With a Coverdell ESA, however, contributing to the account is restricted if you are in a high-income tax bracket. Contributions to a Coverdell ESA start to phase out at a modified adjusted gross income (MAGI) level of $110,000 ($220,000 if married filing jointly) for 2016.
This means you can no longer invest in the account if your income is above that dollar amount.
ESAs are not just for college
One advantage of an ESA plan is that you are allowed to take tax-free distributions for certain elementary and secondary education expenses, such as tuition, fees, books and supplies.
A 529 plan is for college expenses only. You cannot use it for elementary or secondary education costs.
Have you calculated how much you expect to have saved for your kids’ education by the time they are ready for college?