The chance to go to college can open up a world of opportunity for your children. To give them that opportunity, it can help to save strategically, by making use of tax-advantaged accounts intended specifically for college savings.
There are two popular tax-advantaged options for college savings: the Coverdell Education Savings Account and 529 College Savings Plans. We’ll begin with the Coverdell.
If you want to get started early on college savings with modest contributions, a Coverdell ESA may be a good option for you. As with a 529 college savings plan, earnings in a Coverdell aren’t taxed while they remain in the account, so those earnings can grow and compound free of taxes.When the time comes for a withdrawal, those earnings can be distributed tax-free as long as they are used for qualified education expenses.
Because the Coverdell’s main benefits are a function of time, the time that your account has to generate earnings that grow and compound tax-free, starting early will help you get the most out of this account. You also have the option of transferring the Coverdell or rolling over unused amounts to another child or relative in the beneficiary’s family.
Coverdell ESAs come with some requirements. The designated beneficiary, the child that you are saving for, must be less than 18 years of age at the time of your contributions.
Anything held in a Coverdell must be distributed by the time the beneficiary reaches 30, or transferred to a family member who is under the age of 30. These age requirements don’t apply for special needs beneficiaries.
Earnings that are distributed from the Coverdell and are not used for the beneficiary’s qualified education expenses a re subject to income tax, along with an additional 10 percent penalty tax.
Contributions to the Coverdell are after-tax dollars, so that portion of distributions will not be subject to tax.
In 2012, total contributions for each beneficiary for the year are limited to $2,000. (You can make Coverdell contributions from now until April 17, 2012 for 2011, as long as you designate them for the 2011 tax year.)
As a contributor, you can make the maximum 2012 contribution as long as your modified adjust gross income (MAGI) is $95,000 or less for a single filer or $190,000 or less for those filing a joint return. The $2,000 limit is reduced if your income is higher, and phased out completely if your MAGI is $110,000 or more for a single filer or $220,000 or more for those filing jointly.
One potential drawback for the Coverdell is that the current contribution limits may not extend into 2013. The limit for the Coverdell was set at $500 until it was raised to $2,000 by a 2001 tax law. That limit was set to revert back to its original form after 2010, but a 2010 tax law extended the $2,000 limit into 2011 and 2012.
Congress may act to extend the enhanced provisions, which include the $2,000 limit and the use of the Coverdell for K-12 expenses into 2013, but we’ll have to wait and see.
If you plan to contribute more than $2,000 a year for your child’s college education, you can opt for a 529 college saving plan, which we’ll discuss next.
Michael Camacho is president and chief executive officer of Personal Finance Center. He has more than 19 years experience in retail banking and with financial institutions in Guam and Hawaii. You can email him at firstname.lastname@example.org.