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Paying for College With a College Savings Account

Saving money for college can be easier said than done, but several savings and incentive plans make the task easier for many prospective college students and their families. Two of the most common education savings plans are 529 Plans and Coverdell Education Savings Accounts. Both plans allow students and their families to save money with significant tax advantages, but there are distinct differences between education savings plans. Let's take a closer look at these two popular ways to save for college.
 

 

529 Plans

Named after the Internal Revenue Code 26 U.S.C. 529, a 529 Plan comes in one of two forms: prepaid plans and savings plans.
 

 

Prepaid 529 Plans

Prepaid 529 Plans allow students or their families to pre-purchase tuition credits for future use at today's tuition rates. Thus, investors are protected from tuition inflation rates, assuming that tuition rates will continue to rise between the time of purchase and when the student plans to attend college. According to USA Today, 19 states offer a total of 21 prepaid plans, but only plans offered in Mississippi, Massachusetts, and Washington back up their plans with "the full faith and credit of the state" -- meaning that the plans will be guaranteed by the state, regardless of whether the funds lose money. Other states have varying guarantees, so investors should carefully research the terms of the plans offered by their state, particularly the guarantees made to protect the funds' assets.
 

 

529 Savings Plans

529 Savings Plans allow students and their families to purchase investments, usually mutual funds, specifically for qualifying education expenses. The value of the plans is based on the market performance of the funds, and most funds used for these plans become more conservative as the beneficiary (the student) approaches their college entrance year.
 

 

Both Prepaid and Savings plans are professionally managed, and donors can sign up for automatic contributions (in many states, as much as $300,000 can be contributed), providing a seamless way to save for college. IRS forms are not required until the donor begins making withdrawals from the fund, and administrative fees are generally low.
 

 

529 Plan Tax Advantages

Both Prepaid and Savings 529 Plans are exempt from federal income tax, under the terms of the Economic Growth and Tax Relief Reconciliation Act of 2001. The plan principal is tax-deferred as it grows in value, and the distributions are then exempt from taxes as long as they are used for qualifying education expenses*. In addition, many states offer income tax deductions for all or part of 529 Plan contributions. 529 Plans also do not have a significant impact on students' financial aid eligibility, because they are treated as an asset of the account owner (which is usually the parent) under the College Cost Reduction and Access Act of 2007. Finally, unused portions of 529 Plan funds can be transferred to qualifying members of the beneficiary's family without any tax penalties.

* If investors use a distribution from a 529 Plan for something other than qualified education expenses (see section below), the funds are subject to federal income tax and a 10% early distribution penalty, unless certain exceptions are met.
 

 

529 Plan Qualifying Expenses

529 Plan funds can be used to pay for:

  • Tuition and fees at accredited colleges, universities, and vocational schools in the U.S. (and some foreign institutions)
  • Books, supplies, and equipment required for study
  • Room and board, as long as the student is enrolled at least half time

 

 

529 Plan funds cannot be used to pay for:

  • Student loans
  • Student loan interest
  • Books, supplies, and other equipment not required for study

 

 

Coverdell Education Savings Accounts
 

Families can deposit up to $2,000 per year into a Coverdell Education Savings Account in the name of a beneficiary under the age of 18. Earnings accumulate tax-free and can be used toward qualified education expenses, including tuition and fees, eligible room and board, as well as books, supplies, and equipment required for study. When funds are withdrawn, investors do not need to pay taxes as long as the money is used to pay for qualified education expenses, which include college expenses and may also include qualified elementary and secondary school expenses. The account must be closed or transferred to a new beneficiary once the student reaches the age of 30 (if there are still funds in the account), unless the original beneficiary is designated as a special needs beneficiary. Income limits do apply: Contributions can be made by investors who have a modified adjusted gross income under $220,000 (for joint income tax filers) or $110,000 (for single income tax filers).
 

 

More information about 529 Plans  and Coverdell Education Savings Accounts can be found in IRS Publication 970.
 

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