To reward you for saving for your children's college education, U.S. law offers two different tax-advantaged plans: Coverdell Education Savings Accounts and qualified tuition plans, commonly known as 529 plans. Though the tax benefits are tempting, they're not right for everyone, especially if you're not sure that you want eventually to spend the money on education.
The term "tax-free" is a bit misleading when it comes to Coverdells and 529 plans, because you don't get any tax breaks for putting the money in, at least at the federal level. Some states offer deductions for 529 plan contributions. However, they do still offer significant tax savings. Once the money's inside the plan, it grows tax-free. And, as long as you remove the money for qualified educational costs, you don't pay any taxes on the distributions. The savings get exponentially larger the longer the money remains in the account.
Range of Qualified Expenses
Both Coverdells and 529 plans allow you to take qualified withdrawals for post-secondary education expenses, including tuition, supplies, room and board at colleges, universities, trade schools and graduate schools. Coverdells and 529 college savings plans can be used at any school you want. On the other hand, some 529 prepaid tuition plans may limit the maximum benefits to the school or schools covered by the plan, while others may allow you to use the value of your investment to pay for tuition at another school of your choice. Coverdells, but not 529 plans, also offer the option of letting you use the money for elementary and secondary educational costs. For example, if your daughter goes to private high school, the tuition is a qualified expense.
Non-qualified Withdrawal Penalties
The biggest drawback to using a Coverdell or 529 plan is the taxes and penalties that hit non-qualified withdrawals. If you spend the money on something besides the qualified expenses, the earnings portion of the withdrawal is hit with income taxes and, barring an exception, an additional 10 percent tax penalty. Exceptions include amounts not used for qualified costs because the student received a scholarship, money paid to a beneficiary after the death of the designated beneficiary and if the designated beneficiary becomes disabled.
Can't Count for Education Credits
Any education expenses that you pay for with money from your Coverdell or 529 plan doesn't count towards generating an education tax credit, like the lifetime learning credit or the American opportunity credit. For example, if you pay $12,000 in qualified higher education expenses and use $11,000 from a 529 plan, you only have $1,000 in qualified expenses that you can count towards a tax credit. However, if your income is too high to claim a tax credit anyway, there's no loss to you.
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."