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Saving for your kid's college education can seem like a daunting task, but there are a few college savings plans that make it a lot easier. The 529 savings plan and Coverdell ESA offer the two best ways to get a head start and grow those savings substantially over time -- and they're easier to use than you may think.
529 savings plans: high limits and easy investing
Technically, there are two types of 529 plans -- prepaid tuition plans and savings plans. 529 prepaid tuition plans allow parents to pay for their child's college education in advance at today's tuition rates, which could save them truckloads of money down the road if tuition rates continue to skyrocket. However, not many states offer these plans anymore, and some of them are not currently accepting new enrollees. So we'll instead look at 529 savings plans.
Like a Roth IRA, a 529 savings plan does not allow savers to deduct their contributions, but any qualified withdrawals are 100% tax-free. And like a 401(k), a 529 offers a selection of mutual funds for savers to invest in.
529 plans are run by the states, and while you don't have to invest in your home state's plan, many offer incentives to residents, so it's a good idea to check your state's plan first. As a personal example, I use South Carolina's 529 plan for my children, and while contributions aren't deductible on the federal level, I can deduct my contributions on my state tax return. You can check out your own state's plan(s), as well as others, at this excellent directory by Savingforcollege.com.
Contribution limits for 529 plans vary but are generally pretty high -- up to about $400,000 in many cases. In other words, a 529 savings plan can accommodate even the most ambitious college savers.
Money in the account can be used for qualified higher-education expenses, including tuition, room and board, mandatory fees, books, and other supplies required for attendance. If your child doesn't end up using all of the money in the account, it can be easily transferred to another beneficiary, such as another child, a niece or nephew, or even yourself.
Coverdell ESA: more flexible and better investment choices
A Coverdell Education Savings Account, or ESA, is similar to the 529 plan in several ways. Contributions are made on an after-tax basis, and qualifying withdrawals for education expenses are tax-free. Money deposited into the account can be transferred to another beneficiary if the primary beneficiary doesn't need all of the funds.
However, there are a few key differences. First, the contribution limits are much lower -- just $2,000 per year. In other words, over the 18 years between birth and high school graduation, a total of $36,000 can be contributed to your child's Coverdell account. Even if your investments perform well, a Coverdell may not be enough to cover four years of tuition all by itself.
The advantage of a Coverdell ESA is the flexibility it offers, both in terms of investment options and the potential uses of account funds. Unlike a 529 plan, which is limited to a basket of mutual funds, a Coverdell ESA allows you to invest in any stocks, bonds, or funds you want. And qualified uses of the money aren't strictly limited to college costs: Education expenses at any level can be paid for with Coverdell funds. For example, if your child attends a private high school, you can use your Coverdell to help pay the tuition.
One possibility is to use both account types -- a 529 plan and a Coverdell. There's no rule against doing so, and you can take advantage of both accounts' benefits.
There are other options
This is not an exhaustive list of ways to save for college. If you don't want your money committed to educational uses and don't mind giving up the tax benefits, you can use a regular brokerage account to invest.
Better yet, a Roth IRA can be a great option, provided you anticipate having enough retirement savings elsewhere. Not only can Roth contributions be withdrawn at any time and for any reason, but investment gains can also be withdrawn for the purpose of qualified college expenses. To be clear, I'd recommend one of the two college-specific plans discussed above, but this is a valid option.
The bottom line is that there are smart ways to start saving for college, and the sooner you get started, the more time your money will have to grow. So choose the best option for your family and start today.
