The federal government offers two special college fund options that give you tax advantages -- Coverdell Education Savings Accounts and qualified tuition plans, also called 529 plans. You won't get a tax deduction for contributing to either type of plan, but the Internal Revenue Service does offer other tax benefits.
Any earnings you accumulate in your college plan are tax-free as long as the money stays in the account. For example, if you put $2,000 in a Coverdell and it grows to $2,500 because your stocks did really well, that $500 of profits isn't taxed as long as the money stays in the Coverdell. Similarly, if you put $10,000 in a 529 plan and it grows to $12,000, the $2,000 of earnings isn't taxed in the account either.
Tax-Free Qualified Distributions
If you take a qualified distribution from a Coverdell or 529 plan, you get all the money -- both contributions and earnings -- out without paying a penny of taxes. For Coverdells, qualified expenses include elementary school through graduate school tuition, fees and supplies. If the student enrolls at least half-time in post-secondary education, it also includes room and board. By contrast, 529 plans are a bit more restrictive: only money withdrawn to pay post-secondary education expenses counts as a qualified withdrawal. If you use your 529 plan for elementary school or high school costs, it's a non-qualified distribution.
If you take non-qualified withdrawals from either a Coverdell or 529 plan, you must pay taxes on the earnings portion of the distribution. To figure the earnings portion, divide the contributions you made to the account by the account value. Then, multiply the result by the amount of money you withdrew to find the tax-free portion of the distribution. Last, subtract the tax-free portion from the total withdrawal to figure the earnings portion that you must include in your income. For example, say you put in $34,000 to your 529 plan and it's now worth $50,000. To figure the taxable portion of a $10,000 non-qualified distribution, divide $34,000 by $50,000 to get 0.68. Then, multiply 0.68 by $10,000 to find that $6,800 of the distribution is tax-free. Finally, subtract $6,800 from $10,000 to find you must report an extra $3,200 of income when you file your taxes.
Both Coverdells and 529 plans slap the taxable portion of a non-qualified distribution with a 10 percent tax penalty on top of the income taxes. But, not all non-qualified withdrawals have to pay extra. If you're taking the distribution because the beneficiary is permanently disabled or you inherited the college fund, you get the money out penalty-free. You can also take out, penalty-free, an amount up to the amount of scholarships the beneficiary received.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."