Three Tax-Friendly College Savings Options

With tuition costs rising each year, setting aside funds for college can be a daunting task. Here are a few options that may lessen the financial burden of college in a tax-savvy way:

Section 529 plan

Consider putting after-tax money into a Section 529 college savings account. Contributions aren’t deductible, but earnings will grow tax-free in these plans when used to pay qualifying educational expenses.

Plan funds can be used for college tuition, room and board, computers and related equipment. Unused fund earnings are subject to income tax. There are no contribution phaseout limits. However, the account owner’s contributions plus other gifts totaling more than $15,000 for one student may be subject to gift taxes.

Section 529 plans can also be used for up to $10,000 in tuition expenses for elementary and secondary public, private and religious school.

Good for: Parents and grandparents who want to save for their kids’ school tuition and other related expenses while still receiving a tax break.

Coverdell education savings account (ESA)

Another option is this flexible account. You can choose from a wide variety of investments to meet your individual needs, like an IRA.

Funds in this account can be withdrawn tax-free if used for qualified education expenses such as tuition, room and board, books, tutoring and more. If the funds are not spent by the time the beneficiary is 30, the unspent money must be withdrawn (subject to income tax and a 10 percent penalty) or rolled over into another family member’s education savings account.

The maximum annual contribution for a beneficiary is $2,000 – from all sources. Unlike 529 plans, Coverdell ESA contributions begin phasing out for parents with an adjusted gross income (AGI) of $190,000 (single filers with an AGI of $95,000).

Keep in mind that a Coverdell ESA can also be used for elementary and secondary school expenses.

Good for: Students who have education expense costs other than tuition and want additional investment options for education savings.

Custodial account

If you’re looking for a savings option that goes beyond education, a custodial account may work well for you. With Uniform Transfers to Minors Act (UTMA) and Uniform Gift to Minors (UGMA) custodial accounts, you can generally invest in a wider variety of options versus a Section 529 plan.

The funds are considered property of your child. The tax advantage in these accounts comes into play for unearned income up to $2,100 per year, which are taxed at the child’s, usually lower, tax rate. That also means annual investment earnings over $2,100 will be taxed at trust and estate rates.

There are usually no annual contribution limits, but contributions of more than $15,000 may be subject to gift tax rules.

The biggest potential disadvantage is that you gift the funds irrevocably to the child. At a certain age, your child controls the account and could spend the funds on something besides college.

Good for: Parents who give financial gifts to their kids and don’t mind handing over control of the accounts when they reach 18 or older.

College is expensive, so consider maximizing as many tax advantaged options as possible to take some of the sting out of the cost.