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Ask June: Military Family Options for Saving for College

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Q: My husband and I have been discussing investing money for our children's college. We have a nine, six, and three-year-old. We do not plan on funding their full tuition. We both were responsible for paying our own ways through college and feel that it made us more responsible with money and made us value our education a little more since we were paying for it and not on a free ride from our parents. With that said, we would still like to have funds available to help our kids pay for books, food, etc.

As a military family, would a 529 college fund be appropriate for us? Isn't that a state-run fund? We are never in the same state for more than two years at a time, and we are not sure where we will be living when our children finally get to college age. Would a Coverdell account be any better for us? Any guidance is appreciated!

-Jennifer, Fort Rucker, Ala.

A: I appreciate your viewpoint -- there certainly is something to be said for kids having some "skin" in the education game. But, I also like your idea of putting money away to help out when the time comes. You know you'll be tapped for some expenses! This is a big topic, so here goes.

You mentioned two of the three main vehicles that come to mind when I think of socking money away for college: 529 College Savings Plan (529) and the Coverdell Education Savings Account (CESA). Either of these would work well, but let me cover several of the differences between the two plans and then explain a third option.

First, the CESA is currently limited (2010 limits) to a $2,000 per year contribution for each child; whereas most 529 plans have total contribution limits in excess of $200,000 (gift taxes would have to be considered if funding the 529 plan above the annual gift tax exclusion of $13,000 per year per person). You can switch beneficiaries of either plan from one child to another, but ultimate control of the 529 reverts to you, the parent. With the Coverdell, when your child reaches age 30, the account reverts to them, the beneficiary. The CESA can be invested at your discretion in whatever mix of stocks, bonds, mutual funds you choose, whereas the 529 plans typically have a menu of specific investment options, such as age-based options that morph into a more conservative mix as college approaches. Finally, the 529 can only be used for higher education, while the CESA could be used for elementary or secondary school expenses.

In either case, you could benefit from tax deferral and tax-free withdrawals for qualified education expenses.*

An important consideration is that there are 529 "savings" and "pre-paid tuition" plans. Savings plans, regardless of which state sponsors the plan, allows for funds to be used at virtually any school in the United States plus several international venues. The pre-paid plans are best used in the state with which they're affiliated.

Even though you're in the military, you may currently pay state income tax in your state of residency. If that is the case, setting up a 529 plan sponsored by your state may result in some state income tax savings, otherwise, you can choose most plans without regard for the state affiliation. Hopefully, that gives you enough ammunition to choose the plan that's right for you.

The third option is to save in your name or set up a Uniform Transfer/Gift to Minors Account (UTMA/UGMA) in each child's name. Saving in your own name would not provide any special tax benefit, but it would give you the most flexibility. Or, you could set up a jointly owned mutual fund that you and your spouse earmark for educational expenses.

With an UTMA or UGMA you are actually giving the child a gift and invest it in their name. At your state's age of majority (usually 18 or 21) the money becomes the property of the child -- a feature which some parents don't like. After all, college may not sound appealing when you could buy a cool car with that money, right!? Additionally, UTMA or UGMA funds count more against a financial aid application than do the 529 plan or CESA. Also, there are taxes to consider. The first $1,900 (in 2010) of investment income that a child earns is treated favorably, but beyond that, any additional income (capital gains, dividends, interest) are taxed at the parent's marginal rate.  

You didn't ask about it, but an important military family benefit is the Post 9/11 GI Bill. You sound savvy, so I figure you're already taking the potential kids' benefits into consideration.

Whew! Lots to think about!

*Tax-free earnings and withdrawals are for qualified educational expenses. Other withdrawals are subject to income tax and an additional 10% penalty on earnings. The availability of tax or other benefits may be contingent on meeting other requirements.

June Lantz Walbert is a CERTIFIED FINANCIAL PLANNER practitioner with USAA Financial Planning Services. She is also a lieu­tenant colonel in the U.S. Army Reserve with 20 years of service. Walbert's basic branch is Air Defense Artillery. She writes a weekly advice column, "Ask June" on Follow June @AskJune_usaa.

Certified Financial Planner Board of Standards, Inc. owns the certification marks CFP and CERTIFIED FINANCIAL PLANNER in the United States, which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

Views and opinions expressed by members are for informational purposes only and should not be deemed as an endorsement by USAA.

The Motley Fool has a disclosure policy.

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