Q: I'd like to start saving now for my 3-year-old daughter's college education. What's the best type of account?
There are three main tax-advantaged investment accounts you can use to save for college.
A 529 savings plan is an account run by the states, and has high contribution limits. Investment options are set up similar to a 401(k), with a basket of investment funds to choose from.
A Coverdell Education Savings Account, or Coverdell ESA, has lower contribution limits, but gives you the flexibility to invest in virtually any stocks, bonds, or funds you want.
Finally, a Roth IRA is generally thought of as a retirement account, but there's a special provision that lets you use IRA funds for college expenses penalty-free. This could be a smart option if you want the flexibility to eventually use the money for something other than education if you end up not needing it. You could use a traditional IRA, but doing so would likely increase your tax bill significantly in the years when you need to withdraw the money.
All three have the same basic tax structure. Contributions aren't tax-deductible, but withdrawals used for qualifying education expenses are tax-free, no matter how much your investments have grown. Since they are run by the states, many 529 savings plans have the added benefit of state-tax-deductible contributions.
As a parent of young children myself, I primarily use a 529 savings plan for college savings since our state allows 529 contributions to be deducted, but there are certainly advantages to all three. The most important thing is to start early and contribute regularly. Tax-free compounding and time will do the rest.
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