Tax-savvy savings options

CNN Money

529s, Coverdell IRAs and college savings trusts may work for you.

Saving for college is hard not just because it's a huge expense, but because you can't predict how much, if any, financial aid you'll get.

That's why you need to save what you can now. Fortunately, you have a number of tax-advantaged federal and state college-savings vehicles at your disposal. The best option is the state-sponsored 529 plan*, which comes in two flavors: the prepaid tuition plan and the savings plan.

A state's prepaid plan allows you to pay now at today's rates for school tomorrow. In return, your account (or contract as it's often known) is guaranteed to pay for the tuition and fees at the state's public universities and colleges by the time your child graduates from high school. A pre-paid plan often does not, however, cover the costs for room and board.

Your child also may use the pre-paid account to attend a private or out-of-state school but you might risk forfeiting some of its value depending on how the plan values its contracts. Note, too, that most pre-paid plans require that the account owner (you) or the beneficiary (your child) be a resident of the state in which the plan is offered.

At the same time states have been improving their prepaid plans, and private schools have been given the green light to offer their own such deals.

Under the 2001 Tax Relief Act, withdrawals from a private school's prepaid plan were made exempt from federal taxes as of 2004. (Prior to then, you would have been taxed on the increased value of a tuition contract from the date you bought it to the date you redeemed it.)

More than 270 private schools, ranging from tiny liberal arts schools like Ripon College in Wisconsin to well-known universities like the University of Chicago and Wake Forest, have joined forces to offer a prepaid tuition product called Independent 529 Plan. Parents can buy prepaid contracts good for tuition at any of the member schools.

What if your child does not get into any of the schools in the network? "To any of the 270? We check you for a pulse," quipped Douglas Brown, who is president and CEO of the plan. But, he added, if that's the case you can get a full refund with interest.

To learn more about the plan, call 888-718-7878.

The 529 college savings plan, now offered in most states, is far more flexible than the pre-paid tuition schemes, and perhaps safer. (At times, some states have reported that their pre-paid plans were seriously underfunded.) The money may be used at any school you choose and for all qualified higher education expenses, including room and board.

Each state determines what the lifetime contribution limit or account balance cap will be in its 529 plan, but typically such limits range between $100,000 and $270,000. Investment minimums are low (most plans let you sock away as little as $25 a month as long as a minimum of $500 is accumulated within two years of the initial purchase date), and there is no restriction on how much you may contribute every year unless the account is nearing the lifetime cap.

However, since 529 contributions are treated as gifts subject to gift-tax limitations, if you want to make a tax-free contribution, it shouldn't exceed $13,000 annually ($26,000 if you're contributing with your spouse). There's one exception, however: you may contribute as much as $65,000 tax-free in one year ($130,000 with your spouse), but that contribution will be treated as if it were being made in $13,000 installments over the next five years. That means you can't make other tax-free gifts to the beneficiary during that time.

Most 529 savings plans offer a menu of age-based portfolios, and some also offer a small selection of stock and bond funds. In the former case, your annual contributions get invested in a pre-selected portfolio of stocks and bonds. Early on, the portfolio is tilted toward stocks, and as the time for college nears, the weighting shifts toward bonds. You can switch, and it's pretty easy to change. You can do it online. Before you could make only one rollover a year. But now the IRS allows two rollovers per calendar year.

The quality of 529 college savings plans varies by state, but in most instances you may open an account in any state you'd like.

All 529 plans offer generous tax breaks, provided you use the money for qualified expenses. While your contribution is not deductible on your federal taxes, your investment will grow tax-deferred and withdrawals will not be subject to federal tax. In prior years your money had grown tax-deferred and earnings withdrawals were taxed at the student's income tax rate.

What's more, you get state-tax deductions on contributions or exemptions on withdrawals.

Another tax-advantaged option is the Coverdell Education Savings Account (formerly known as the Education IRA). You can contribute up to $2,000 a year and withdrawals are tax-free. To qualify for a full or partial contribution, your adjusted gross income must be less than $110,000 if you're single; $220,000 if you're married and filing jointly.

One of the drawbacks is that the annual contribution cap is per child, meaning if you and your parents want to contribute to an account for your daughter, your combined contributions can't exceed $2,000.

You may now contribute to both a 529 and a Coverdell Education Savings Account on behalf of the same beneficiary in the same year without penalty, but your contributions will be treated as gifts subject to gift-tax limitations. For more on 529 plans, check the Web site

*As with any investment, the principal value and investment returns of any 529 plan will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. The investment risks associated with any 529 plan also will depend on the mix of investments in the plan. Tax benefits and expenses vary by state and by 529 plan. You should obtain personal advice from qualified professionals regarding the rules for 529 plans in your state before making any investment.

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