If you have children who will be attending college in a few years, you recently got a nice pre-enrollment gift from the government. Specifically, the Tax Relief Act of 2001 enhanced the Coverdell Savings Plan (formerly the Education IRA) and Section 529 plans, giving you more attractive options for college funding.
Let's take a look at how these plans compare in some key areas:
• Tax advantages - Your contributions to a Coverdell Savings Plan are not tax-deductible, but all earnings and withdrawals are tax-free, provided you use the money for qualified education expenses. (The new tax law also allows Coverdell Savings Plans to be used to help fund elementary and secondary school education).
Section 529 plans are offered as either prepaid tuition plans or state-sponsored college savings accounts. Until the Tax Relief Act, you would have had to pay taxes when you took distributions from your 529 plan. These taxes were based on either the increased value of the tuition contract or the savings account earnings. The taxes were assessed at the student's tax rate, but they still had to be paid. However, starting in 2002, all qualified withdrawals will be free from federal income tax, although the money will appear on the child's tax return.
• Contribution limits - Effective in 2002, if you meet certain income limits, you can contribute $2,000 a year to a Coverdell Savings Plan, up from just $500. By contrast, Section 529 plan contribution limits are typically quite high - more than $200,000 per beneficiary in many state plans. You also can contribute as little as $15 per month, although contribution limits vary by state. (Before making any major contributions to a Section 529 plan, you'll want to consult with your tax adviser, because gift and estate tax laws may be involved.)
•Investment options - A Coverdell Savings Plan offers you an almost limitless array of investment options -stocks, bonds, certificates of deposit, etc. If you establish a Section 529 college savings account, you can choose from the investment options offered by the particular state's plan that you've selected.
• Effect on financial aid - Because a Coverdell Savings Plan must be set up in the child's name, a college's financial aid office will count it in his or her assets when calculating aid packages. Colleges generally require children to contribute about 35 percent of their assets for college costs, compared with less than 6 percent of parents' assets. On the other hand, a 529 plan's savings account is considered your asset, with your child or grandchild the beneficiary. However, any money you withdraw from a 529 plan will show up as income on your child or grandchild's tax return this year - and this income, although not federally taxed, will be considered for aid the next year.
As you can see, you must consider several factors before establishing either a Coverdell Savings Plan or a Section 529 plan. Fortunately, you no longer have to choose between the two; the new tax laws allow you to invest in both simultaneously, beginning in 2002.
Whichever path you choose, get started soon. College costs continue to increase rapidly - so you'll want to be ready when you get that first bill from the bursar's office.