Q: Like many people, I need to make my savings grow for both my
retirement and my child's education expenses. What kinds of savings
or investment vehicles can I use to increase my education savings?
A: It's important to work with a financial advisor who can examine
your particular situation and help you find the most productive way
to balance your savings for both retirement and education expenses.
However, there are two useful savings vehicles that you should be
sure to discuss with your advisor: Coverdell Education Savings
Accounts (formerly and still commonly called Education IRAs) and 529
plans (named for Internal Revenue Code Section 529).
A Coverdell Education Savings Account (ESA) is a tax-sheltered
account, opened on behalf of a child that is under age 18. As of
2002, you may contribute up to $2,000 each year to your account (up
from $500 in previous years), with a contribution deadline of April
15 of the following calendar year. Your ESA advisor will help you to
increase your account by investing your contributions in various
ways. Your contributions are not tax deductible, but the withdrawals
are tax-free if used for qualified expenses. Qualified expenses
include many costs of an elementary, secondary, or college education
(such as tuition, fees, tutoring, books, supplies, room and board,
transportation, special needs, a computer system, educational
software, and Internet access). Eligibility limits do apply. Your
ability to participate in an ESA will be phased out for an adjusted
gross income of $190,000 to $220,000 for joint filers and $95,000 and
$110,000 for single filers. If you plan to use an ESA to fund a
child's college expenses, be sure to consult with an advisor first.
ESAs are more likely to benefit higher-income families with children
who probably won't be eligible for financial aid. Lower- to middle-
income families may lose more financial aid than they will save in
taxes, because ESAs (which must be opened in the child's name) are
counted as the child's assets and will likely reduce the amount of
aid that he or she can obtain.
529 plans are state-sponsored accounts that support college
education expenses and enjoy tax benefits at both the state and
federal level. 529 plans come in two forms: a prepaid tuition plan
and a savings plan. States may offer one or both plans. In a prepaid
tuition plan, you purchase a chosen amount of tuition (in years or
other units) at today's rates, by making either monthly installments
or a one-time lump payment. The state will then pay for that same
amount of future tuition at any of the state's participating colleges
or universities. (Or, it may pay an equal amount for tuition at
private and out-of-state institutions.) The savings plan offers a
variable rate of return on the money you invest, with some states
guaranteeing a minimum rate of return. All earnings are exempt from
federal taxes. Tax benefits at the state level vary. Many states
offer full or partial tax deductions for your contributions and full
exemptions for your earnings.
The basic differences between ESAs and 529 plans are that ESAs are
self-directed, so you decide where to purchase the ESA and who you
will work with to help you invest your money. A 529 plan is more
like a savings account, where the state takes the money and does the
investing for you. ESAs generally have no state tax benefits, but
some states may offer tax benefits for 529 plans. Also, ESAs can be
used for primary and secondary education, but 529 plans are for
higher education only. Finally, ESA funds may affect your child's
eligibility for financial aid. As always, consult with your
financial advisor to help you decide what is right for you and make
the most of your savings dollars.