I was surprised to read the results of a recent survey showing that just 28% of U.S. adults know what a 529 college savings plan is. And I was even more surprised that only a slightly higher percentage of respondents with children (32%) were aware of 529 plans.
If you have a college-bound child, it would benefit you (and them) greatly to have a working knowledge of 529 plans and Coverdell Education Savings Accounts.
Here’s your short-course on the two primary tax-advantaged ways to save for college.
529 plans
These plans were creatively named for the IRS code section that governs them.
Taxes. Available in every state, all 529 plans allow investors to grow their money tax-free, assuming the funds are used to help pay for college. If you invest $10,000 and it grows to $20,000 by the time you start tapping the account to pay for tuition and other college bills, no tax will be due on the $10,000 you earned on your investment.
In addition, some states provide a state income tax deduction on your contributions. In Illinois, for example, a married couple filing a joint tax return can deduct up to $20,000 of 529 plan contributions per year.
Other states provide a tax credit. In Indiana, for example, those contributing to the state’s 529 plan are eligible for a 20% tax credit on up to $5,000 of contributions, which would knock $1,000 off their state income tax bill.
Contribution amounts. There are no income restrictions that limit who can contribute to a 529 plan, and contribution limits are very liberal. Up to $14,000 may be contributed per parent per beneficiary each year without triggering the federal gift tax.
How to invest the money. Most plans offer a few different investment options, the most popular of which are age-based portfolios that work much like target-date mutual funds. They start out very aggressive, tilting heavily toward stocks. Then, as the beneficiary gets closer to age 18, the portfolios automatically become more conservative.
What the money can be used for. 529-plan money can be used for qualified higher-ed costs, such as tuition, room and board, books, and student fees at most two- and four-year colleges and universities, technical and vocational schools, and grad schools. Importantly, your child does not need to choose a school in the state that administers your 529 plan. The money can be used at schools throughout the country and even some schools outside the U.S.
Next steps. Every state offers a 529 plan, so start by looking at yours. If it offers a tax deduction or credit, that would be a significant reason to go with your state’s plan. Otherwise, several organizations, such as Savingforcollege.com and Morningstar, rate plans based on their fees, investment options, and more.
Coverdell Education Savings Accounts
These accounts were named for the late Senator Paul Coverdell, who championed their creation. You can open a 529 plan and a Coverdell account for the same student.
Taxes. Just like 529 plans, Coverdells allow education savers to grow their money tax-free. However, there are no state tax deductions or credits for the money you contribute.
Contribution amounts. With a Coverdell, you are much more limited in how much you can contribute each year — no more than $2,000 per beneficiary.
There are also income limits that govern who can contribute to such an account. If you’re single, you have to earn less than $95,000 to make the full $2,000 annual contribution. If you’re married and filing jointly, household income must be less than $190,000.
How to invest the money. You have much greater latitude when investing Coverdell funds. Wherever you open the account, you will have most of that broker’s or mutual fund company’s investment options at your disposal.
What the money can be used for. Here’s one of the most important distinctions between 529 plans and Coverdells. Whereas 529 plan money can only be used for college costs, Coverdell money can be used for K-12 costs as well, including private school tuition and uniforms, tutoring, and a computer.
Next steps. Some of the more familiar brokers that offer Coverdell accounts include TD Ameritrade, Schwab, and Scottrade. Several mutual funds offer Coverdells as well, including The SMI Funds, which are affiliated with my day-job employer, Sound Mind Investing.
College isn’t getting any less expensive. So, if you’d like to help your kids cover the cost, use every advantage available to you, such as 529 plans and Coverdell Education Savings Accounts.
In our household, we have 529 plan accounts for each of our three kids (now ages 8-13) that we opened when each one was born. Looking back, I wish we had opened Coverdell accounts as well, and we still might.
How are you saving for college?
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