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Saving for college is almost a must these days, when tuitions are escalating and the demand for education is soaring. There are several options for parents and grandparents, with varying tax benefits. None offers a straight deduction from taxable income on federal returns. However, 34 states and the District of Columbia offer local tax incentives on some plans.
A 529 plan, named for the section of the Internal Revenue Service code that authorized it, is the most popular college savings option. Its contributions and earnings are tax-free when withdrawn for education. All 50 states and the District of Columbia offer at least one version. Contribution amounts are limited only by the federal gift tax limit of $13,000 a year, and most can total $250,000 or more.
Another savings program is a Coverdell account, also called educational savings, created like an individual retirement account at a financial institution. Coverdell funds also grow tax-free and are exempt on withdrawal if used for educational expenses, which are not limited to college. Contributions are limited to $2,000 a year. But there is no limit on the number of accounts that can be set up for one beneficiary, who must be younger than 18.
UGMA and UTMA
Custodial accounts are another option, under the Uniform Gift for Minors Act or Uniform Transfer to Minors Act. These are savings accounts created for a minor child.
Assets in the account are considered irrevocable gifts, so the practical limit on contributions is the $13,000 federal gift exclusion, which is not deductible. The account passes to the child at some age, and its assets count against college financial-aid calculations.
The 529 program offers two options, savings account or prepaid tuition plan, both exempt from taxes when used for education. A 529 savings account is invested in mutual or money market funds. Its earnings are tax-free if used for higher-education expenses, including tuition and room and board, at any higher educational institution.
Prepaid tuition plans can be created by a college or group of schools. A contributor pays in advance for a specified term, such as a semester, at a participating school.
Income tax deductions vary by state, but most are limited to contributions to 529 plans in that state. However, Kansas, Maine and Pennsylvania allow deductions no matter where the plan is established.
Some states, like Virginia and Wisconsin, limit deductions to $2,000 or $3,000. Virginia even allows account owners to deduct contributions by others.
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