If you’re starting to save for college costs, there are a variety of accounts with special tax structures you could consider to help your savings grow. Remember, it’s never too early (or too late) to start saving, and saving little by little over time can really add up. Here are a few examples of tax-advantaged college savings accounts.
529 college savings plans
529 savings plans are flexible, tax-advantaged accounts designed specifically for education savings. Any earnings on contributions grow federal income tax deferred. Typically, a parent or guardian opens the account and names the child or another minor as the beneficiary. Each plan is sponsored by an individual state, often in conjunction with a financial services company that manages the plan. Although you don’t have to be a resident of a particular state to invest in its plan, you should check with your home state first for any benefits it may offer.
529 savings plans offer a way for family and friends to gift contributions to your child.
You can withdraw from a 529 plan at the college-level to pay for qualified expenses such as for tuition, fees, books, supplies, and approved study equipment including computer technology, related equipment and software. You can also make withdrawals to pay for qualified expenses up to $20,000 per calendar year at the elementary through high school levels. When used for qualified expenses, 529 plan withdrawals are not subject to federal income tax.
Uniform Gifts to Minors Act/Uniform Transfers to Minors Act (UGMA/UTMA)
UGMA/UTMAs are custodial, investment accounts opened to save and invest on a child's behalf. They are sometimes called fiduciary accounts because they must be managed on behalf of the minor, who is the beneficiary. Although typically the custodian may be a parent or guardian, and the minor is the child, they don't have to be related. Again, the minor is the official owner, while the custodian manages the account.
UGMA/UTMA accounts allow parents and guardians (and/or others) to make irrevocable gifts to a minor that can be used for college or any other expenses beyond education. (For some, this may be a good fit for those who aren't sure if their child will attend college.) All money contributed must be used for the benefit of the minor. For federal tax purposes, any investment earnings are generally taxed at the minor’s tax rate (also known as kiddie tax1), which is usually lower than a parent’s rate.
Unlike with a 529, the beneficiary cannot be changed. With UGMA/UTMA accounts, once the minor reaches the age of majority (typically between 18-25, depending on the state), the account must be transferred to them.
Coverdell Education Savings Account (ESA)
Similar to a 529, Coverdell ESAs can be used to pay for a range of qualified education expenses, federal income tax deferred. However, the annual contribution limit is $2,000 annually, per beneficiary. This means that even if multiple accounts are opened (let's say, between the parents and grandparents), the maximum contribution limit is $2,000.
Coverdell ESAs are not suitable for high income earners due to income restrictions. You are eligible to use a Coverdell ESA if your annual income is less than $110,000 (singles) or $220,000 (couples).
Contributions to the Coverdell ESA are no longer permitted after the age of 18. Also, if the beneficiary reaches age 30, any remaining funds must be distributed within 30 days after their 30th birthday, unless the beneficiary has special needs.