First things first: why contribute to a 529 college savings plan or a Coverdell ESA? The short answer is that money accumulated in these accounts can be withdrawn tax free when used to pay for qualified education expenses. Here are a few of the details:
529 college savings plans - These accounts receive a lot of attention and for good reason. They are investment plans sponsored under state and federal tax laws that allow gift-tax free contributions and tax deferred growth of investments.
While there is no federal tax deduction for contributions, most states allow a tax deduction or tax credits when their residents make contributions to their states sponsored 529 plan. Also, qualified distributions used for education expenses are income tax free.
Many of these state-sponsored college savings programs allow accounts to be opened with as little as $25, allow contributions in amounts of as little as $25 a month and can be added to by automatic deductions from a checking account or paycheck. Most providers of 529 Education Savings accounts have a menu of investment options and offer a menu of investment funds suitable for a child's education goals and time horizon. Some of the main drawbacks include that some plans offer a limited line up of investment fund options and individual stocks cannot be owned in these accounts.
Coverdell Education Savings Accounts - These accounts come with the tax benefits of 529 accounts but allow more investment flexibility. Think of these accounts as being similar to a Roth IRA where only the tax-free withdrawals are limited to higher education expenses.
Coverdell Education Savings Accounts can be opened through most brokerage companies, an adult must be the custodian, and the child is the beneficiary of the account. The downside is that there are new rules affecting Coverdell ESAs in 2011. Only distributions used for post-secondary education are tax-free. The annual limit on contributions to these accounts this year is $2,000 per child, but next year that also changes to $500. One of the drawbacks is that there are income limits for Coverdell ESA contributions and only folks who meet these income limits are allowed to contribute to a Coverdell ESA. One way around that is to make a gift to a lower income family member and they in turn can make a contribution to the child's account.
One of the best features of these accounts is that you have more investment control and flexibility because like most brokerage accounts, you will have the ability to invest in mutual funds, exchange traded funds and individual stocks and bonds.
But do not delay. If contributing to these accounts is something you want to do, then do it now. Contributing to a 529 Plan account sponsored by your state may allow you to claim a tax deduction on your states income tax return for contributions made this year.
Also, the limit for contributions to Coverdell Education Savings Accounts is $2,000 this year. But if you wait until January 2011, the contribution limit is reduced to only $500. A strategy to maximize contributions to these accounts is to open and contribute to a Coverdell ESA now and then contribute to the account again in January. If you do this, you'll have contributed $2,500 towards the college savings of a child.