One way is a 529 plan, which is usually run by a state or education institution. Contributions to the plan are not deductible on Form 1040, but your distributions from the plan to pay for your child’s college expenses are federally tax-free. As well, certain states that offer these plans will allow for contributions to the plan to be deductible on your state tax return, or allow for tax-free distributions. There is also typically no maximum contribution limit. Different states offer different tax benefits, so make sure to compare the state plans if this is the route you should choose.
Another way to save for your child’s college is with a
Coverdell Education Savings Account (ESA). You can contribute up to a
maximum of $2,000 per year, but the contributions are not deductible for tax
purposes. However, the income grows tax-free in the account, and
distributions are not taxed as long as they are used for qualified education
expenses, to include elementary and secondary school expenses (something 529
plans do not allow). Another benefit of a Coverdell ESA is that it offers
a wider range of investment options than a 529 plan, which typically only
offers mutual funds, or whatever the state run program chooses to allow.
Choosing which method to go about saving for your child’s
college education may seem overwhelming, but by knowing the differences between
these two common methods, you can make an educated choice. Both of these
two choices allow for tax free distributions, however, the key areas of
contrast between the two plans are the contribution limits, investment types,
and state tax breaks. Consider these areas to determine which plan best
suits your needs.
William A. "Bo" Taber III, CPA
