Q: My spouse and I are starting to save for our kids' education. Should we use a 529 savings plan, a Coverdell, or some other type of account?
There's no perfect answer to this question, and the best choice depends on which account type's benefits work best for you.
For most people, one of three options (or a combination thereof) is the way to go: the 529 savings plan, Coverdell ESA, and/or a Roth IRA. Here's a quick rundown of the major differences between the three.
529 savings plans are offered by the states, and allow you to invest in a selection of investment funds, similar to a 401(k). Contribution limits are high ($400,000 or more in many states), and depending on your state, you may get state-specific tax benefits. Any withdrawals used for qualifying higher education expenses are tax-free.
A Coverdell Education Savings Account's (ESA) main drawback is its contribution limit of just $2,000 per year. However, contributions can be invested in virtually any stocks, bonds, or funds you want, and you can use it for education expenses at any level, not just college. In other words, if your child ends up going to a private high school, you can use funds from a Coverdell ESA to help with tuition.
Finally, a Roth IRA is not typically thought of as a college savings account, but it does have some benefits. Unlike the other two, Roth IRA funds aren't considered for financial aid purposes, which could make it easier to get need-based financial aid. There is an exception that allows IRA withdrawals for higher education expenses, so you don't have to worry about any early withdrawal penalty. Finally, Roth IRAs are flexible. Funds in a 529 savings plan or Coverdell must be used for education. On the other hand, if your child doesn't need the money in a Roth IRA, you can simply use it for your own retirement.
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