Q. What are the best tax-smart ways to save for college?
A. There are quite a few options, depending on your needs as a family and your savings goals. Here's a quick rundown of my favorite investment options for college:
UGMA (Uniform Gifts to Minors Act) Parents of young children can start saving now for higher education, but should do so in a tax-smart way. By investing in a UGMA in your child's name, the income is taxed at your little one's marginal tax bracket rather than yours. At age 18 or 21 (depending on the state), control of the assets is turned over to your child, who can use them toward college. Note: This can be a disadvantage when it comes to financial-aid qualifications.
EE US Savings Bonds If the income from these bonds is used to pay for education expenses, it may be excluded from taxes, depending on your income level.
529 College Savings Plan This education savings plan, operated by a state or educational institution, is designed to help families set aside funds for future college costs. As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to plan participants. Most notably, the money invested grows tax free, provided that you use it for eligible education expenses (such as tuition, room, board, and books). Grandparents and other relatives can also contribute to a 529. These plans are usually categorized as either prepaid or savings plans, although some have elements of both. Every state offers a 529 plan, and it's up to each to decide on the particulars, such as tax exemptions and credits. Go here to review your state plan.
Coverdell Education Savings Accounts A Coverdell lets you set aside up to $2,000 of pre-tax income to be invested as you like, assuming your family meets the modified adjusted gross income requirements. The funds must be spent before your child turns 30. On the plus side, they can also be used for private-school tuition prior to college. Because Coverdell funds can be rolled over into a 529 without penalty, parents can sidestep its principal drawbacks—the age limit and the fact that a Coverdell counts as a child's asset (which can adversely affect his ability to receive need-based loans). Coverdells may be a smart investment option for parents whose income is below $50,000. The accounts are easier to set up than 529 plans, and people in this lower tax bracket aren't usually able to take advantage of the maximum lifetime contributions allowed under a 529.
Free money Signing up with Upromise.com lets you get a percentage of your everyday purchases at grocery stores, gas stations, and other places you frequent anyway deposited into your child's 529 account. Anywhere from 1 percent to 25 percent of each sale is deposited into your child's 529. Be sure to have grandparents sign up and log in their spending too (they'll need to set up their own 529 accounts to take advantage).
Ellie Kay is a family financial expert, the author of The 60-Minute Money Workout, and a mom of seven. Read more of her advice at elliekay.com.
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