Tax-Free College Savings

Don't miss out on government savings programs created to help with college costs.

Paying for college has grown incredibly expensive—far outstripping the rate of inflation. According to the College Board, a student entering college in the year 2020 will pay more than $85,000 at a public university for a four-year education, and a whopping $225,000 at a private college. That’s a lot of money. Fortunately, the government has created several methods to help you save enough for college for your children or yourself.

Coverdell ESA: The Education IRA

Coverdell ESAs (short for Education Savings Accounts) are named after a late U.S. Senator who helped create the program. A Coverdell ESA is much like a Roth IRA except that it is used only for education expenses. Here’s how it works.

  • You open an account with a bank, brokerage, or mutual fund company that offers Coverdell ESAs. The account is a trustee or custodial account like an IRA, with a person below age 18 named as beneficiary—this can be your child, grandchild, or anyone else. You decide how the money in the account should be invested. As with IRAs, there are a wide array of investment choices.
  • Up to $2,000 per year can be deposited, in cash, into a Coverdell ESA for the beneficiary, until he or she reaches age 18. You can have an ESA for each of your children and each can receive $2,000 in contributions every year.
  • Anyone can make contributions if their income is below specified levels-$110,000 for singles and $220,000 for taxpayers filing joint returns.
  • Contributions to Coverdell ESAs are not tax deductible, but the funds in the account grow tax free.
  • The money in the account may be withdrawn at any time and is tax free to the child and parents as long as it is used for “qualified education expenses.” These include tuition, fees, books, supplies, and equipment to attend an accredited college. Qualified education expenses also include expenses to attend elementary or secondary school—for example, a private high school or parochial school. This is a unique feature of the Coverdell ESA.
  • If the money taken from a Coverdell ESA is used for noneducational purposes, the account earnings are taxed to the beneficiary at ordinarily income rates, plus a 10% penalty is imposed.
  • When the beneficiary reaches age 18, he or she takes over control of the account.
  • The money in a Coverdell ESA must be spent by the time the beneficiary reaches age 30.

529 Savings Plans

529 savings plans are named after Section 529 of the tax code—the provision that establishes them. They are also called Qualified Tuition Programs or QTPs for short. 529 savings plans are more complicated then Coverdell ESAs, but you can contribute much more money to them. They have become very popular with parents in recent years, but you should do careful research before you invest in one.

529 savings plans are very different from Coverdell ESAs. First of all, unlike other tax-advantaged accounts, 529 plans must be sponsored by state governments or state agencies. Every state has some type of 529 plan; some have several. However, the states do not actually run the plans. Instead, they enter into agreements with investment companies to operate them—these firms manage the investments in the plan. You must pay annual management fees to the investment company—part of which go to the state—which makes 529 plans a big moneymaker for state governments. Here’s how 529 savings plans work:

  • You open a 529 account with the investment company that operates the plan you want to invest in. Anyone can open a 529 account, in any state. Unlike Coverdell ESAs, there are no income restrictions on the individual contributors.
  • There are no annual limits on how much you can contribute to a 529 plan (although there are overall contribution limits).
  • Contributions to a 529 account are not deductible from your federal taxes. However, over half the states allow a state income tax deduction if the account owner is a state resident.
  • The money in 529 account grows tax free. Withdrawals are tax free as well if they are used for qualified educational expenses. However, unlike a Coverdell ESA, 529 plan money may not be used to pay for elementary or secondary school expenses—for example, you can’t use it to send your child to a private high school or parochial school.
  • If you withdraw money from a 529 plan and do not use it on an eligible college expense, you generally will be subject to income tax and an additional 10% federal tax penalty on the earnings from the account.

U.S. Savings Bonds

United States savings bonds may not be as sexy as 529 plans or Coverdell ESAs, but they can be a good way to save for college. The interest earned on U.S. savings bonds is not subject to state or local taxation, but it ordinarily is subject to federal income tax. If you do not include the interest in income in the years it is earned, you must include it in your income in the year in which you cash in the bonds.

Certain bonds issued under the Education Savings Bond Program—Series EE and Series I—may be cashed in without paying any federal or other tax on the interest if the money is used to pay tuition and fees to enroll yourself, your spouse, child, or other dependent at any accredited college, university, or vocational school. Only Series EE bonds purchased after 1989 qualify for tax-free treatment (Series I bonds are not subject to this rule). The bond must be issued either in your name (as the sole owner) or in the name of both you and your spouse (as co-owners). The bond owner must be at least 24 years old before the bond's issue date. The issue date is printed on the front of the savings bond. In addition, there is an income limit to qualify for tax-free treatment of the interest.

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