Many parents and grandparents are aware of the benefits of 529 college savings plans. Earnings in these plans grow tax-free, and withdrawals aren’t taxed either if the money is spent on higher education for the account’s beneficiary. In addition, many states offer benefits for contributions to a 529 plan, such as matching grants, as well as state income tax deductions.
However, the tax code offers several other benefits to help make it easier to pay college costs. They include the following:
Coverdell Education Savings Accounts
Like 529 plans, these vehicles offer investment income and withdrawals for education expenses free of taxation. The catch, though, is that contributions are limited to $2,000 per year per student, and the student must be under age 18 when the account is opened. With 529 plans, contributions can’t exceed the dollar amount needed to pay for the beneficiary’s education, but just about all 529 plan limits exceed $250,000.
Nevertheless, Coverdell ESAs offer some significant advantages. For one, these plans are offered by a number of financial firms and institutions. Once you set up an account, you may have a broad range of investments from which to choose. If you’re an experienced investor you can direct Coverdell contributions where you’d like, into low-cost mutual funds, for example, or into investments with exceptional upside potential. With 529 plans, which are professionally managed, you have less control. Moreover, 529 plans limit tax-free withdrawals to post-high school expenses. With a Coverdell you can tap the account for K-12 costs as well as college bills, tax-free. You might use a Coverdell to pay for private school or for academic tutoring, for example. The Tax Relief Act of 2010 extends the tax provisions of Coverdell ESAs through tax year 2012.
A married couple’s income cannot exceed $190,000 to make the full $2,000 Coverdell contribution; for single taxpayers, the income limit is $95,000. If that’s a problem, you can give the money to someone with a qualifying income—perhaps a retired grandparent—who can make the $2,000 contribution for you.
If you are self-employed, a professional, or a business owner, you may be able to shift income from your high tax bracket to a child who’ll owe no or low taxes. The savings on your tax bill can then go toward a college fund.
Suppose, for example, Dr. Alice Duncan, a self-employed physician, hires her teenage daughter Kim to work weekends and school holidays to maintain her office’s IT system and help with billing and other tasks. Over the course of a year, Kim works 500 hours and receives $15 an hour, which is the going rate for such work in their town.
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