All parents want their children to achieve their fullest potential -- and most agree that education is the key. But how to save up for the steep cost of schooling? If you choose a private school for your child, these costs can begin at preschool and continue on right on through college and grad school.
In fact, education bills will be among your heaviest financial burdens as a parent. Fortunately, there are a number of tax-advantaged strategies you can use to maximize the savings you sock away for your child's education, primarily in the form of education saving accounts. Here is a brief overview of your best savings options.
Coverdell Education Savings Accounts
By far the most flexible education savings plan, a Coverdell education savings account (Coverdell ESA) provides tax-free treatment for your investment earnings. Although this type of account caps the amount you can save ($2,000 per year), and doesn't allow contributions after the child turns 18, you can use the money for a broad array of educational expenses -- such as private school tuition, academic tutoring, and a computer for high school -- in addition to college and graduate school tuition.
A few aspects of Coverdell accounts are set to expire in 2012. Unless Congress acts, you will no longer be able to use Coverdell ESAs for K-12 education, and the cap on how much you can put into the account annually will plummet to $500.
529 College Savings Plans
These plans -- which are offered by individual states, but come with federal as well as state tax benefits -- allow you to save substantial amounts for your child's higher education expenses. (Despite being state run, however, 529 plans can still be used for out-of-state college tuition, so long as your child attends a qualified school.) The contribution limits vary by state, but in many cases are as much as $300,000 per beneficiary. You won't owe any federal taxes on the appreciation.
The major drawback to this type of plan is that it covers only college and graduate school expenses. Private high school, for example, doesn't count. Also, be aware that contributions are treated as gifts under federal law and are subject to federal gift tax rules. However, a special exception for 529 plans allows you to spread a large lump-sum contribution over five years in order to avoid gift tax liability. To learn more about federal gift tax, see Nolo's Estate and Gift Tax FAQ.
529 Prepaid College Tuition Plans
As the name suggests, these plans allow you to pay for tomorrow's college tuition (but not for books, supplies, or other related costs) at today's prices. Although they can be a bargain, the plans limit your child's college choice to the schools participating in the program. Many plans also limit your options to schools in the state where your child is a resident, though there is a plan that allows you to save up for any of a limited group of private colleges.
Note that these are not investment accounts -- you don't earn profits on your money. If you decide to withdraw the money (or roll it over into another plan, which is possible in certain circumstances), you'll be paid interest at a low rate.
And, these plans aren't risk-free -- many are seriously underfunded. At least one prepaid tuition plan has shut down completely and several others are no longer accepting new enrollments. Before you make contributions, do some due diligence. Find out about the financial health of the plan and what will happen to your money if it shuts down.
Education Savings Bonds
If you're more concerned about losing your money in an economic downturn than interested in profiting from a bull market, U.S. savings bonds offer a guaranteed (but small) return on your original investment. You will not owe any taxes on the interest you accrue on a Series EE or Series I savings bond, provided you use the money to pay for your child's college or graduate school bills. However, if your income rises above certain limits (which can change annually), you won't be eligible to participate.
Although these accounts are not specifically for education savings, they allow you to give money directly to your child without the expense and administrative hassle of setting up a conventional trust. You don't have to spend the money in your child's custodial account on your child's educational expenses, but can instead spend the money for your child as you see fit. Although there is no tax exemption for custodial accounts, the earnings in the account get taxed at your child's lower rate rather than your tax rate.
Although a Roth IRA is technically a retirement plan, a nifty exception allows you to withdraw money from your Roth IRA -- without paying a penalty -- to cover your child's higher education expenses. The Roth IRA is best for slightly older parents, who won't owe any taxes on the earnings if they withdraw money from the account after reaching age 59Â½. (Before age 59Â½, you'll owe taxes on the earnings, but not on your original contribution, if you take money out to pay for higher education.) A major drawback to the Roth IRA is that the distribution will be taken into account for purposes of the student's federal financial-aid application for the following year.
To find out more about choosing a savings plans, how to open an account, and how much you need to save, see Parent Savvy: Straight Answers to Your Family's Financial, Legal and Practical Questions, by Nihara Choudhri (Nolo).