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Saving For College

Many college expenses can be covered by student loans and current income, but with the cost of tuition rising rapidly, many families try to save as much as possible to cover the price tag of higher education. Families often invest in stocks, bonds and mutual funds in order to get a solid rate of return.

There are two college savings investment vehicles that offer tremendous tax benefits-the Coverdell Education Savings Account and Section 529 plans.

What are Coverdell Education Savings Accounts?

Coverdell Education Savings Accounts, formerly called Education IRAs, were created in 1997 and work much like individual retirement accounts, except they are intended for college savings instead of retirement savings. Coverdell accounts are set up for a designated beneficiary and contributions are added to it over the years. Account owners can invest the money in whatever mix of stocks, bonds, cash or mutual funds they choose, just as they could with an IRA. When the designated beneficiary needs the funds for school, distributions can be taken from the Coverdell account to cover qualified education expenses.

How much can I contribute to a Coverdell account?

A maximum of $2,000 per year can be contributed to a beneficiary's Coverdell account. You need to be careful if multiple family members are making contributions to one child's account-their total contributions cannot exceed $2,000 per year without triggering a penalty. Contributions can be made until the beneficiary reaches 18 years of age.

What are the tax benefits of Coverdell accounts?

Earnings accumulate tax-free in a Coverdell account. Distributions for qualified expenses are exempt from federal taxation. But if you make withdrawals for anything other than qualified expenses, those distributions are taxed as ordinary income and subject to a 10 percent penalty.

Contributions made to the account do not qualify as federal or state income tax deductions.

What expenses can the funds cover?

In order to be exempt from federal income taxes, distributions must be used for qualified education expenses at a qualified educational institution. Qualified expenses include tuition, fees, books, supplies, transportation and equipment needed for enrollment or attendance.

Qualified educational institutions include any school that participates in federal student aid programs administered by the Department of Education. The school should be able to tell you if it qualifies.

Beginning in 2002, Coverdell accounts could also be used to pay for qualified primary and secondary school expenses. Computers are a qualified expense for elementary and secondary school students, even if computers are not required by the school. However, computers are a qualified expense for college students only if they are required by the college.

Do I have to meet a certain income threshold to participate in these accounts?

Yes. Your income must be below a certain level in the year you make a contribution. To make the maximum $2,000 contribution, you must have adjusted gross income of less than $95,000 if you are a single filer or less than $190,000 if you are married and filing jointly. The contribution amount is gradually phased out for those with incomes between $95,000 and $110,000 for single filers and between $190,000 and $220,000 for married individuals filing jointly.

If your income is above the allowable limit, you can bypass the phase-out by gifting the maximum $2,000 contribution to your child through a custodial account and then having the child contribute it to the Coverdell account.

How do I set up a Coverdell account?

You can set up a Coverdell account through banks and mutual fund companies, the same way you would an IRA. Simply complete the enrollment forms provided by the custodian. You must name the beneficiary and a "responsible individual"-usually yourself. You can invest the money in any mix of qualifying investments, such as stocks, bonds, mutual funds and cash-but not life insurance.

Who owns the Coverdell account-the parent or the child?

Coverdell accounts can be owned by either the parent or the child. But whoever is named as the "responsible individual" has decision making authority over the account. The parent can transfer that authority to the child once they reach the age of majority-or not.

Regardless of who owns the account, all withdrawals must be paid to the beneficiary. The funds cannot be refunded to the parent.

Any unused funds must be distributed to the beneficiary within 30 days of his or her 30th birthday. Earnings will be taxed as ordinary income plus a 10 percent penalty. Before the beneficiary turns 30, the "responsible individual" can change the beneficiary to another qualifying family member under the age of 30 to avoid the tax and penalty. Qualifying family members include the original beneficiary's child, stepchild, sibling, stepsibling, nephew, niece, first cousin, brother-in-law, sister-in-law and the spouse of any of these relations-as long as they are under the age of 30.

How will funds from a Coverdell account be treated when applying for federal aid?

Funds from Coverdell accounts are considered an asset of the account owner when applying for federal student aid. Qualified tax-exempt withdrawals are not considered as income to the student or the parent.

What is a "529 plan"?

Section 529 plans, named after the Internal Revenue Code section that governs them, are very attractive college savings investment vehicles. Each state sponsors its own 529 plan through its state treasurer's office. Section 529 plans vary considerably from state to state.

In some plans, you can choose from a menu of investment options. In other plans, the investment mix is determined by the age of the child-with aggressive investments when the child is young and conservative investments as the child approaches college age.

How much can I contribute to a 529 plan?

Contributions to 529 plans qualify for the $11,000 annual gift tax exclusion. By law, you can give up to $11,000 per year to as many different people as you want without triggering the gift tax. In addition, your spouse can give up to $11,000 per year to the same people you gifted. So, for example, a husband and wife could give their child a combined $22,000 per year without paying gift taxes. Therefore, a couple could contribute that amount to each child's 529 plan every year. You can contribute the full allowable amount to as many 529 plans as you want.

With 529 plans, you are allowed to accelerate 5 years' worth of contributions to a beneficiary in 1 year without paying gift taxes. That is, individuals could contribute up to $55,000, and married couples could contribute up to $110,000 to a 529 plan in 1 year. Accelerating the funding of a 529 plan removes assets from your estate faster and enables the money to grow longer in the plan. However, if you accelerate the full allowable amount, you cannot gift any more money to that person for 5 years. Once that time period is up, you can resume contributions up to the limit.

Under federal law, the states must prevent people from using 529 plans as a tax shelter and contributing more money than could reasonably be used by one person to pay for higher education. Therefore, each state sets its own limits on the total amount that can be contributed to each beneficiary's 529 plan, ranging from $146,000 to $305,000 for 529 savings plans and $50,000 to $100,000 for 529 prepaid plans.

Most states allow you to make both lump sum contributions and regular automatic transfers.

What are the tax benefits of 529 plans?

Earnings grow tax-deferred. Withdrawals from 529 plans, when used for qualified college expenses, are exempt from federal income tax. In almost all cases, withdrawals are also exempt from state income tax. In most states, your contribution to a 529 plan counts as a full or partial state tax deduction and can usually be carried forward for up to 5 years.

If you cancel your 529 account and have the balance refunded to you, which you are allowed to do, you have to pay income tax on the earnings plus a 10 percent penalty.

Section 529 plans are excellent estate-planning tools. Because you can contribute up to the annual gift tax exclusion limit, with the option to accelerate 5 years' worth of gifts, to as many people as you want, you can exclude a significant amount of assets from your taxable estate without giving up control of those assets.

What expenses are covered by 529 plans?

Qualified expenses for higher education include tuition, fees, books, supplies and equipment needed for enrollment or attendance at a qualified higher-education institution. Computers only qualify as a covered expense if the school requires students to have them. Qualified educational institutions include any school that participates in federal student aid programs. Some states allow 529 plan funds to pay for graduate school as well.

Who can participate in 529 plans?

Anyone can participate in 529 plans. There are no income limitations or age restrictions.

What is the difference between 529 prepaid tuition plans and 529 savings plans?

There are two types of 529 plans: prepaid programs and savings programs.

  • Prepaid tuition plans allow you to prepay future college tuition costs at today's tuition prices. They are generally intended for in-state public colleges. The value of the 529 account is guaranteed to increase at the same rate as college tuition in that state. If the student decides to attend a private or out-of-state college, the plan pays an amount equal to the average in-state college tuition, which may or may not cover all the student's needs.
  • Most prepaid tuition plans require that either the account owner or the beneficiary be a state resident when the account is opened. Participating in a state's prepaid tuition plan does not guarantee that the child will be accepted at a state school.

  • Savings plans do not lock in current tuition prices, and they provide no guarantee that the student will have enough funds to cover the cost of college. But they do offer the possibility of earning a greater return, and you can use the full value of your account at any accredited college or university in the country. Some foreign schools qualify as well.

In both the prepaid programs and the savings programs, the owner who sets up the account names a beneficiary and maintains control over the account.

Every state has at least one type of 529 plan available.

How do I decide which 529 plan to pick?

In many cases, you can participate in any state's plan, regardless of where you live or where the child intends to go to college. But you should investigate a plan's residency requirements and ability to transfer funds out of state first. If your state offers a state income deduction for contributions, that should weigh heavily in your decision. Finally, make sure you are comfortable with the plan's investment options and compare fees and expenses to other plans. You may also want to consider the maximum contribution limits.

TIP: Find your state's 529 program at www.savingforcollege.com/529_plans/state_pages/index.php.

Compare 529 programs at www.savingforcollege.com/529_plans/the_529_evaluator/index.php.

What expenses are typically associated with 529 plans?

Some programs have enrollment fees of between $10 and $90. There is typically an annual account maintenance fee of $25 to $30, but that is often waived if you sign up for automatic contributions or if you account exceeds a certain balance. Asset management fees range from 0.15 to 0.7 percent of the account balance. There may also be expenses associated with the underlying mutual funds, which could range from 0.10 to 2 percent.

Who has control over the account-the parent or the child?

The owner of the account, usually a parent or grandparent, controls the funds. The beneficiary has no rights to the funds and does not assume control of the account upon reaching the age of majority. The owner decides when withdrawals are made and for what expenses.

If the beneficiary does not go to college or does not need all the funds in the account, the account owner can have the balance refunded. The owner will have to pay ordinary income tax on the earnings plus a 10 percent penalty. Or the owner can make another family member the beneficiary and avoid paying taxes and the penalty. If the new beneficiary is not a family member, the change is treated as a taxable distribution to the account owner.

How will funds in a 529 plan be treated when applying for financial aid?

The federal financial aid formula treats 529 savings plans as an "asset" of the parent, grandparent or other account owner, which receives a much more favorable assessment in determining aid than a child's asset does.

However, 529 prepaid accounts are treated as a "resource" and generally count dollar-for-dollar against financial aid eligibility because it reduces your child's overall need by that amount.

Depending on the state, 529 plans may or may not affect eligibility for state aid, and every school has its own rules for determining need.

Can I contribute to both a Coverdell and a 529 plan for the same child?

Yes. But your combined contribution to the Coverdell account and the 529 plan cannot exceed $11,000 per beneficiary per year-or you will have to pay gift taxes.

TIP: As a general rule of thumb, it is better to save assets in the parent's name than in the child's name for financial aid purposes. In determining how much aid a student will receive, the federal formula takes into account 35 percent of student assets, while the formula only considers 5.65 percent of parental assets. Also, if a grandparent saves assets for a child's education, few schools require those funds to be reported on aid applications at all.