(By Nilus) In last week's column, I discussed the basics of 529 plans and explained why they can be a powerful way to save for a loved one's college education. But I also casually mentioned other alternatives like savings bonds and Coverdell education savings accounts.
Today, I want to discuss those two other choices a bit more so you can weigh them against the nearly-ubiquitous 529 plan.
Let's start with savings bonds, which are one of the oldest ways to save for higher education costs.
Using Government Bonds for College Expenses …
Both traditional savings bonds (Series EE) and the newer inflation-protected savings bonds (Series I) can be used to fund a child's college education.
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These bonds are issued by the U.S. Treasury and are considered among the most conservative investments available. That's because they are essentially guaranteed by the full faith and credit of the United States Government. (Yes, even though that might not mean quite what it used to!)
Let's first address the elephant in the room — neither of these investment categories are going to pay you a huge return given current interest rates. However, as I've explained in past columns, I-Bonds may actually be a reasonable buy right now for very conservative investors.
Regardless, the main advantage of using these instruments is that they couldn't be easier to buy and hold. You don't even need to open a special account of any type. Instead, you can just go to your local financial institution or visit www.treasurydirect.gov.
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What's more, you don't need lots of money to get started — even a $25 initial investment is good enough!
The best part is that the interest you earn will be fully exempt from state and local taxes as long as the proceeds are used for qualified education expenses. That's something to consider when you compare the relatively paltry yields to other investment choices.
However, beyond the low returns, there's one other major catch: The interest exemption only applies to tuition expenses … NOT room, board, books, or other costs. Moreover, there are income restrictions to contend with.
Enter the Coverdell Accounts, Something I Use for My Daughter …
Coverdell Education Savings Accounts used to be known simply as Education IRAs, and while they're not really "retirement" accounts, they DO function very much like Roth IRAs designed for young students.
Like Roth IRAs, they allow you to sock away money — $2,000 a year, in this case — by tax day.
While that's not an eye-popping number, it's still a nice chunk of change that will add up over the years.
And like Roth IRAs, as long as the funds are used for the benefit of schooling costs, any returns earned in the account will be distributed free of additional taxation going forward.
Another cool feature of Coverdell accounts is that — unlike 529 plans and savings bonds — they can be used for expenses related to ALL types of schooling: High-priced pre-K classes, private secondary education, and even many associated costs such as computers and books.
And While Coverdells Also Have Income Restrictions …
You Can Easily Get Around Them With One Simple Step!
Technically, you cannot fund a Coverdell if you have a modified adjusted gross income above $110,000 filing singly or $190,000 married filing jointly. Phase-outs kick in at lower levels, too.
But here's where it gets interesting — even a child with no earned income can contribute to a Coverdell!
So if you're above the income threshold, you can just gift the $2,000 to the child under the Uniform Transfer to Minors Act and they can put it in the Coverdell themselves.
Yes, it's a stupid formality, but if it works in your favor, go with it!
And please note that you can establish a Coverdell for ANY child in your life — not just a direct relative but even a friend's child or grandchild. Corporations and trusts are also free to establish Coverdells.
Just know that a Coverdell's beneficiary can only have $2,000 contributed to his or her account in any given year. So you should always ask whether an account already exists and how much has been deposited before establishing one on your own. Contributions must also be made before the beneficiary turns 18.
Also, a Coverdell beneficiary has to use the funds before turning age 30, or else taxes and penalties will likely be owed. However, the account can always be switched to another beneficiary before then — even if the new recipient is between ages 18 and 30!
Bottom line: You don't get the potential for up-front tax deductions that you do with 529 plans … and they may not be as conservative as savings bonds … but Coverdells are a unique way to sock away a little extra money for someone special.
Plus, they can be fully funded alongside 529 plans or savings bond purchases so there's no reason you have to choose one over another!
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