Personal Finance Tips for Starting a College Fund

Saving for college can be daunting, with just one year of tuition costing well into the five figures. You can start saving as soon as your child is born. The sooner you start contributing, the sooner you can take advantage of the tax-advantaged growth offered by Coverdell education savings accounts and qualified tuition plans, also called 529 plans.

Coverdell ESAs

“You may want to use the Coverdell,” according to Erin Baehr, a certified financial planner practicing in Stroudsburg, Pennsylvania, and Randolph, New Jersey, “when paying for elementary school or high school is a factor, as Coverdell distributions can be used to pay private school tuition prior to college.” Of course, Covderdells also allow you to take distributions for college as well. “Coverdells also allow for more choice in investments, and investments can be changed more than once a year, unlike the 529,” notes Baehr. Coverdells aren’t without their downsides, however. First, each child can only have $2,000 contributed to a Coverdell on their behalf each year. For example, if you put in $2,000 for your son, his grandparents aren’t allowed to contribute to your son’s Coverdell for the year. Also, you can’t contribute if your modified adjusted gross income is too high. As of 2013, the limit is set at $110,000 for singles and $220,000 for joint filers. In addition, Baehr cautions that “funds in a Coverdell must be withdrawn by the time the beneficiary reaches age 30.”

529 Plans

“A 529 plan in general has more flexibility than a Coverdell,” according to Baehr. “The 529 can accept much higher contributions — up to the amount that will be necessary to fund the child’s education expenses.” The 529 plans also don’t have income limits on who can contribute or age limits on when the money must be used. The 529 plan offers two flavors: prepaid tuition plans, where you buy credits at today’s prices that can be used for tuition in the future at a specific school or group of schools, and college savings accounts, where you invest the money in one of the portfolios offered by the 529 plan. With a college savings account, you can only change your portfolio once per year, but the money can be used at any college or university.

Though you might be thinking there’s no way to know where your newborn is headed for college, Baehr says a prepaid plan could still make sense, “if your prepaid tuition plan allows the flexibility to choose schools. Some prepaid plans do in fact limit your choice to a short list of schools, but others allow you to convert your investment to use at other private or state schools. An alternative may be a guaranteed savings plan, which would allow you to purchase credit equivalents at today’s prices, guaranteed to rise at the college rate of inflation and usable at any accredited US school.”

Early Withdrawal Penalties

Before you start stashing your college savings in a Coverdell or 529 plan, make sure you won’t need the money for other purposes. Once the money is in either plan, any earnings you withdraw count as taxable income and, barring an exception, is hit with a 10 percent extra tax penalty. Distributions are taken proportionally from your contributions and earnings. Exceptions to the penalty include the death or disability of the beneficiary, scholarships received by the beneficiary, or the beneficiary attending a U.S. military school. For example, say the 529 plan has $15,000 of contributions and $5,000 of earnings. If you take a $2,000 distribution for anything besides college or graduate school, $500 counts as taxable income and you’re hit with a $50 tax penalty.

Gift Tax Implications

Any money that you contribute to a Coverdell or a 529 counts as a gift to the child. “While you may contribute a substantial amount to a 529 plan without penalty, you may run into a situation where you need to file a gift tax return,” notes Baehr. As of 2013, the annual gift limit is $14,000 per person. So, you and your spouse could each put in $14,000, for a total of $28,000, in each of your child’s college saving funds every year. Contributions over that limit count as taxable gifts, which, unless you’ve already given massive gifts, will just use up your unified credit — your lifetime exemption on gifts, combined with an exemption on your estate when you die — which is $5.25 million as of 2013.

For example, if you inherit $50,000 and want to put it all in your daughter’s 529 plan immediately, you must file a gift tax return. But, unless you’ve already used up your $5.25 million gift and estate tax exemption, you won’t owe any gift taxes — you’ll just use up a portion of your unified credit. However, 529 plans offer a special option not available for Coverdells: you can elect to have the large 529 plan contribution treated is if it were given over five years. For example, if you make that election with a $50,000 contribution, it’s treated as giving $10,000 each year over the next five years, well under the $14,000 exemption limit.