529 college savings plan
The 529 college savings plan is a state-sponsored tax deferred account that allows you to sock away money for college. The money may be used at any school you choose and for all qualified higher education expenses, including room and board.
Each state determines what the lifetime contribution limit or account balance cap will be in its 529 plan, but typically such limits range between $100,000 and $270,000. Investment minimums are low (most plans let you put away as little as $25 a month as long as a minimum of $500 is accumulated within two years of the initial purchase date), and there is no restriction on how much you may contribute every year unless the account is nearing the lifetime cap.
However, since 529 contributions are treated as gifts subject to gift-tax limitations, if you want to make a tax-free contribution, it shouldn't exceed $14,000 annually ($28,000 if you're contributing with your spouse). There's one exception, however: you may contribute as much as $70,000 tax-free in one year ($140,000 with your spouse), but that contribution will be treated as if it were being made in $14,000 installments over the next five years.
Most 529 savings plans offer a menu of age-based portfolios, and some also offer a small selection of stock and bond funds. In the former case, your annual contributions get invested in a pre-selected portfolio of stocks and bonds. Early on, the portfolio is tilted toward stocks, and as the time for college nears, the weighting shifts toward bonds. You can switch, and it's pretty easy to change. You can do it online. Before you could make only one rollover a year. But now the IRS allows two rollovers per calendar year.
The quality of 529 college savings plans varies by state, but in most instances you may open an account in any state you'd like.
All 529 plans offer generous tax breaks, provided you use the money for qualified expenses. While your contribution is not deductible on your federal taxes, your investment will grow tax-deferred and withdrawals will not be subject to federal tax. In prior years your money had grown tax-deferred and earnings withdrawals were taxed at the student's income tax rate.
What's more, you may get state-tax deductions on contributions or exemptions on withdrawals.
For more on 529 plans, check the Web site www.savingforcollege.com.
A handful of states offer prepaid plans, which allow you to pay now at today's rates for school tomorrow. Many, including Florida, Illinois and Washington, charge more than today's tuition for their prepaid plan. In return, your account (or contract as it's often known) is guaranteed to pay for the tuition and fees at the state's public universities and colleges by the time your child graduates from high school. Florida's pre-paid plan covers the costs for room and board; many other plans do not cover room and board.
Your child also may use the pre-paid account to attend a private or out-of-state school but you might risk forfeiting some of its value depending on how the plan values its contracts. Note, too, that most pre-paid plans require that the account owner (you) or the beneficiary (your child) be a resident of the state in which the plan is offered.
Private schools also offer their own such deals. More than 270 private schools have joined forces to offer a prepaid tuition product called Independent 529 Plan. Parents can buy prepaid contracts good for tuition at any of the member schools.
Withdrawals from a private school's prepaid plan are exempt from federal taxes.
What if your child does not get into any of the schools in the network? You'll get your money back plus or minus the fund's return capped at +/- 2%.
Coverdell Education Savings Account
A Coverdell account, formerly known as the Education IRA, allows you to contribute up to $2,000 a year and withdrawals are tax-free. To qualify for a full or partial contribution, your adjusted gross income must be less than $110,000 if you're single; $220,000 if you're married and filing jointly.
One of the drawbacks is that the annual contribution cap is per child, meaning if you and your parents want to contribute to an account for your daughter, your combined contributions can't exceed $2,000.
You can contribute to both a 529 and a Coverdell Education Savings Account on behalf of the same beneficiary in the same year without penalty, but your contributions will be treated as gifts subject to gift-tax limitations.