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