By Jason Watson (Google+)
When you consider that a dollar today can pay for college tomorrow, then yes they may be worth it. Educational Savings Accounts (ESA’s) are a great way to pay for someone to go to college in future years. ESA’s come in the form of either state 529 Plans or Coverdell Savings Accounts.
529 Plans
State 529 Plans are categorized into two categories: prepaid plans or savings plans.
Prepaid plans let you put money away today, at today’s rates, to pay for college in the future. That’s regardless of how much the cost of tuition rises! A predetermined amount is established, you pay it over time, and the plan pays for college in the future.
The downside is that generally, prepaid plans are reserved for in state residents and are typically limited to in-state public colleges. So, if Johnny wants to go to Harvard or Yale, this plan option is probably not for you.
Savings plans, the alternative, function similar to an IRA account. Essentially, you put money in it, a money manager takes control of the investment, and the investment grows. The maximum limits vary, but many plans are capped around $300,000, some higher. More good news, you aren’t limited to purchasing a plan in your own state. You can live in Colorado, by a plan in Nevada, and go to college in New York. Why would you do that? Because some states have fewer fees and better performing plans. For this reason, shopping around is highly recommended!
What’s the catch? 529 savings plans have limited investment options. If your savings plan isn’t performing well, you can only switch plans once a year.
Ultimately, 529 plans have unsurpassed tax savings. The combination of tax free earnings at the federal level with some states offering additional state tax deductions, make these plans highly attractive. However, each state is different and the plans vary widely from state to state.
And, and this is the big AND, your plan must qualify in your state for a state deduction. In other words, for those residents of Colorado looking for a state deduction from Colorado need to have invested into CollegeInvest or some other Colorado-based plan. The devil is in the details.
The other side of this includes the proximity of the contribution and withdrawal. In a theoretical world you could contribute $10,000 on a Tuesday and withdraw $10,000 of it on Wednesday to pay for tuition on Thursday, you are eligible for a state credit if your state allows for it (again, such as Colorado).
Coverdell Education Accounts
Coverdell Education Accounts function like an IRA account. They have wider appeal because the money can be used for any grade level in any private, public, religious, and post-secondary schools. Further, anyone can open an account and designate any child as the beneficiary; meaning no relationship between them needs to exist. Unlike 529 plans, Coverdell accounts also allow you to control the growth potential by choosing and changing the investment options.
Contributions are limited to $2,000 a year, can be made up until the child’s 18 birthday, and the funds must be distributed by their 30th birthday. While the contributions are non-deductible for federal tax purposes, the earnings grow tax free. One caveat to keep in mind is that a 6% excise tax is imposed if contributions exceed the annual limit and will continue to be imposed if the excess money remains in the account. Watch out for that one!
What makes this account attractive is that the earnings are not taxable when used to pay for qualified education expenses. Just make sure the withdrawals do not exceed the education expenses for the year. If they do, any amounts exceeding education expenses are fully taxable.
Just one more technicality, contribution maximums begin to phase out when with certain income levels are reached by the account holders. These contribution limitations begin if your income reaches $110,000 (single) or $220,000 (married filing jointly).