Two Instruments for College Savings

Parents with young children are faced with many rewards and challenges. One of which may be saving for the high cost of a college education which for public colleges is nearing $25,000 per year. However, there are two tax-favored options that might be beneficial: a qualified tuition program and a Coverdell education savings account. These options each have their benefits and limitations, but similar to how tax planning should be thought of year round, it’s better to make the investment in your child’s future sooner, as opposed to later, so you realize the greater tax savings.

Qualified Tuition Program (QTP) (also known as a 529 plan for the section of the Tax Code that governs them) may be a state plan or a private plan. A state plan is a program established and maintained by a state that allows taxpayers to either prepay or contribute to an account for paying a student’s qualified higher education expenses. Similarly, private plans, like Oppenheimer’s Private College 529 Plan, provided by colleges and groups of colleges allow taxpayers to prepay a student’s qualified education expenses. These 529 plans have, in recent years, become a popular way for parents and other family members to save for a child’s college education. Though contributions to 529 plans are not deductible, there is also no income limit for contributors.

529 plan distributions are tax-free as long as they are used to pay for qualified higher education expenses for a designated beneficiary. Qualified expenses include tuition, required fees, books and supplies. For someone who is at least a half-time student, room and board also qualifies as higher education expense.

Coverdell education savings accounts are custodial accounts similar to IRAs. Funds in a Coverdell ESA can be used for K-12 and related expenses, as well as higher education expense. The maximum annual Coverdell ESA contribution is limited to $2,000 per beneficiary, regardless of the number of contributors. Excess contributions are subject to an excise tax.

Entities such as corporations, partnerships, and trusts, as well as individuals can contribute to one or several ESAs. However, contributions by individual taxpayers are subject to phase-out depending on their adjusted gross income. The annual contribution starts to phase out for married couples filing jointly with modified AGI at or above $190,000 and less than $220,000 and at or above $95,000 and less than $110,000 for single individuals.

Contributions are not deductible by the donor and distributions are not included in the beneficiary’s income as long as they are used to pay for qualified education expenses. Earnings accumulate tax-free. Contributions generally must stop when the beneficiary turns age 18, except for individuals with special needs. Parents can maximize benefits, however, by transferring the older siblings’ account balance to a younger brother, sister or first cousin, thereby extending the tax-free growth period.

Of course, in planning for higher-education costs, parents may also choose to use funds from an individual retirement account (IRA) or a traditional form of savings. In addition, higher education costs may be supplemented with scholarships, loans and grants. However, having a viable plan as early as possible in a child’s life will make maximum use of a family’s financial resources and may provide some tax benefit. When exploring these opportunities, be sure to work with a qualified tax professional.