Taxable Investments

The first college savings option to consider is taxable investments such as savings or mutual fund accounts. Besides being available to anyone, these accounts offer advantages that include being able to use them for non-education-related expenses and there are no limits on the amount you can invest in these accounts. The disadvantage is that taxable investments offer no special tax advantages, which you can find in other education-related savings accounts that we will discuss later; and, because there are no restrictions on these accounts, you may be tempted to use the money for something unrelated to your child’s education.

If you set up a taxable investment for college savings, you should consider whether to put the accounts in your name or your child’s. If accounts are set up in your name, you will pay more in taxes than you would with other tax-efficient assets such as savings bonds, 529 plans, and others discussed later in this article.

Setting up accounts in the name of your child (under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act) could affect his or her eligibility for financial aid. Generally, if there is a good chance your child will qualify for financial aid, it makes sense not to put accounts in your child’s name.

However, if you do open accounts in the name of your child, you could use the gift-tax exemption to transfer money from your accounts to your child’s. Currently, the gift-tax exemption is $13,000 per individual or $26,000 per married couple.

Savings Bonds

Series EE and Series I savings bonds offer tax benefits on gross income when they are used to cover qualified college education expenses. The various bond programs have different rules regarding when you can start to save, how you can save, and what expenses you can cover with the savings. In general, the biggest advantage of savings bonds is that they are safe investments because they are backed by the full faith and credit of the U.S. government. But keep in mind that their earning potential may not be as high as that of other types of investments, and also that there can be income tax consequences when you cash in the bonds, depending on your tax bracket.

Credit Card Rebate and Loyalty Programs

Credit card rebate and loyalty programs provide you with benefits in exchange for shopping at particular stores or buying certain products or services. Some programs provide rebates, others provide a reward in the form of tuition benefits. Popular programs include Upromise, BabyMint, and the SAGE Scholars Tuition Rewards program. Both the costs to participate in these programs and the benefits they offer vary. Before you choose one, do some research to determine which one is best for you. Although these programs may help, by themselves they will not be enough to fund your child’s education. And, for rebate programs to pay off, you should only purchase things you would have purchased anyway. Avoid the temptation to increase your spending to gain rewards — don’t try to “spend your way to prosperity.” 

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (formerly called Education IRAs) allow you to make cash contributions toward the education of children age 18 and under. Although contributions are not tax-deductible, you do not have to pay taxes on the earnings or on most withdrawals.

Coverdell accounts also offer a wide range of investment options, and they can cover a wide range of expenses. In fact, the funds in these accounts are not limited to payment of higher education expenses. They can also be used to pay for your child’s education from kindergarten through undergraduate and graduate study.

Some drawbacks to Coverdell accounts:

• You might not be able to contribute to these accounts if your modified adjusted gross income for the year exceeds $110,000 (or $220,000 if you are married and file a joint tax return). 
• Contributions are limited to $2,000 per year (the maximum amount you can contribute will be less if your modified adjusted gross income exceeds $95,000 or $190,000 if you are married)
• The savings must be used to pay qualified education expenses before your child reaches age 30 or the money in the account is taxed (although you may be able to roll over the remainder tax-free to the Coverdell account of another beneficiary in your family who is under age 30). Amounts not used to pay qualified education expenses are subject to both ordinary income tax and a 10% penalty.
• The amount you save in these accounts may reduce the amount of financial aid your child is eligible to receive.

Section 529 Plans (also known as Qualified Tuition Programs)

With a Section 529 plan, you establish an account on behalf of a designated beneficiary to cover college costs or to pre-pay tuition at a state school. These plans are state-sponsored and vary by state with respect to tax incentives, plan costs, investment options, and the permitted uses of the savings. Section 529 plans offer many advantages:

• Participation restrictions are minimal
• The amount you can contribute is fairly large.
• The money can be used for more than just tuition (including room and board, books, and supplies).
• The beneficiary of the account does not have to attend college in the state that sponsored the account.

Section 529 plans also allow friends and relatives to contribute, which can ease your savings burden. Plus, you don’t have to participate in your state’s plan, but your state may offer certain benefits to residents. There are some drawbacks to Section 529 plans that should be considered. Nonqualified withdrawals are taxed at the account holder’s current tax rate, and a penalty tax may be applied. In addition, the investment options offered under a Section 529 plan may be somewhat limited.

Education Exception to Additional Tax on Early IRA Distributions from Traditional or Roth IRAs

Generally, if you take a distribution from your IRA before attaining age 59½, you must pay a 10% early distribution tax in addition to paying income taxes on the taxable portion of your distribution. However, you can take distributions from your IRA for qualified higher education expenses without paying the 10% early distribution tax. Note that this exception does not apply to hardship withdrawals taken from a 401(k) plan to pay education expenses. Tapping your IRA for education expenses may make sense if you set aside more than enough for your retirement (and do not have enough set aside elsewhere to fund your child’s education). However, it is often not a good idea to raid your IRA to pay education expenses; for one thing, you may have to pay current income tax on the taxable portion of your IRA distribution and, for another, the reduction in your tax-advantaged savings balance can have the effect of permanently lowering your standard of living in retirement. Although your children may appreciate the extra help paying for college, they may not appreciate you showing up on their doorstep because your IRA funds ran out and you can’t make ends meet in retirement.