If you plan to contribute to your child's college education, there's no better time than now to get started. In fact, the earlier you start, the easier it will be, and not just because you'll be able to set aside more of your money. By giving your money more time to compound, you can dramatically boost the value of your savings.
With that in mind, there are two great options that allow you to set aside money for college and let it grow tax-deferred. Here are the two best ways to save for college, and the pros and cons of each.
529 savings plans
These plans are administered by the states, and allow you to contribute money to compound tax-deferred, and any withdrawals for qualified education expenses are tax-free.
529 savings plans are structured similarly to 401(k) plans in that you'll have an assortment of investment funds to choose from, and you can allocate certain percentages of your portfolio to different funds.
The maximum amount you can contribute depends on which state's plan you choose to participate in (it doesn't need to be your home state's plan), but the limits are usually pretty high. In fact, many plans allow for account balances well in excess of $300,000 per beneficiary, which should take care of tuition and expenses at pretty much any college or university, especially when factoring in investment gains.
And, money from 529 plans must be used for qualified higher education expenses in order to be withdrawn tax-free. So, expenses having to do with say, private high school wouldn't be eligible.
It's also worth noting that contributions to either account mentioned here aren't deductible on your current Federal income taxes, but many states allow contributions to be deducted on your state tax return. In this respect, these accounts work more like a Roth IRA, where you pay taxes on the money now, but not on your investment gains later on.
Coverdell Education Savings Account
These are similar to 529 plans in that your savings grow tax-deferred and can be used for qualifying education expenses tax-free. Other than that, there are several differences you should know about.
First, a negative difference. A Coverdell ESA only allows for maximum contributions of $2,000 per year per beneficiary. So, with this account type it's very important to start as early as possible in order to take advantage of compounded gains, as I'll explain in detail later.
Now for a couple of positive differences. Most notably, in a Coverdell ESA, you aren't limited to the selection of funds offered by the plan, like you are in a 529. Rather, you are free to invest in pretty much any stocks, bonds, or funds you choose. You have much more control over how your money is invested.
Also, Coverdells can be used for any qualifying education expenses, not just college. If there is a possibility of your kids attending a private high school, for example, a Coverdell ESA might be a great choice for you.
What if my child doesn't go to college?
This is one of the most popular questions from people who are considering one of these account types. And, there are two answers.
First, if you choose to simply take the money out, you'll most likely have to pay income taxes plus a 10% penalty on any investment gains. So, if you contribute $10,000 and it grows to $15,000, you'll have to pay income tax and a penalty on the $5,000 in investment gains.
However, you can roll the funds over to an account in someone else's name, as long as they are a qualified relative of the beneficiary. And, pretty much any reasonably close relative qualifies.
Early and often
To illustrate the importance of starting early, consider that a $2,000 contribution that grows at 7% per year will grow to nearly $4,000 after 10 years. However, if you let that amount compound for 18 years (like the amount of time it takes a newborn to reach college age), it will grow to almost $6,800. In other words, your earlier contributions matter most in the long run.
So, whichever account type you choose, the important thing is to get started as early as possible, and continue to make regular contributions until your child reaches college age. If you do that, you might be surprised how quickly your savings can build up.