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Coverdell Education Savings Accounts
Formerly known as the Education IRA, the Coverdell Education Savings Accounts let families with adjusted gross incomes of up to $220,000 save up to $2,000 a year tax-free for education expenses (for single filers, the income cap is $110,000).
It's a very good entry-level college savings plan because it works for families who can afford to save only a little bit each month and for those who plan to use the funds to pay for private elementary and high schools. The big appeal of Coverdells is you have a lot more investment options than 529s. However, Coverdell savings count against you when schools award financial aid because they are held in the student's name.
Custodial Accounts
With the latest tax cut, custodial accounts, known as Uniform Gifts or Transfers to Minors Act accounts, now deserve a second look. The new, lower capital-gains tax rate means that most kids pay only a 5% tax on any gains in their stock portfolio. You have more flexibility to spend the money for expenses other than college tuition (as long as it's spent on behalf of the child), and you have a broader choice of investments than in 529 plans and even Coverdells. Potential drawbacks: Kids get control of the accounts once they become adults, and distributions can hurt your chances of getting financial aid.
Savings Bonds
Middle- to low-income households seeking a safe investment may want to consider savings bonds, such as Series EE bonds issued after 1989 and all Series I bonds. The 2004 limitations are as follows: For single taxpayers, the tax exclusion begins to be reduced with a $59,850 modified adjusted gross income and is eliminated for adjusted gross incomes of $74,850 and above. For married taxpayers filing jointly, the tax exclusion begins to be reduced with a $89,750 modified adjusted gross income and is eliminated for adjusted gross incomes of $119,750 and above. Married couples must file jointly to be eligible for the exclusion. So if Mom and Dad separate, there are problems. .
Now lets look at the limitations of your qualified expenses: qualified expenses include tuition and fees (such as lab fees and other required course expenses). The expenses may be for the benefit of you, your spouse, or a dependent for whom you claim an exemption. Expenses paid for any course or other education involving sports, games, or hobbies qualify only if required as part of a degree or certificate-granting program. The costs of books and room and board aren't qualified expenses (and these expenses aren’t cheap!). (Qualified State tuition plans are also included among eligible expenses.) The amount of qualified expenses is reduced by the amount of any scholarships, fellowships, employer-provided educational assistance, and other forms of tuition reduction. Expenses must be incurred during the same tax year in which the bonds are redeemed.
So what’s the deal here? You must use both the principal and interest from the bonds to pay qualified expenses in order to exclude the interest from your gross income. If the amount of eligible bonds you've cashed during the year exceeds the amount of qualified educational expenses paid during the year, the amount of excludable interest is reduced pro rata.
Example: Assuming bond proceeds equal $10,000 ($8,000 principal and $2,000 interest) and the qualified educational expenses are $8,000, you could exclude 80 percent of the interest earned, which would equal $1,600 (.8 x 2000).
If your child doesn't go to college, you won't be penalized for using the proceeds for something else, though, of course, you won't get the tax break. The rub with savings bonds are low returns. The current rate on EE Series savings bonds is just 2.66%. That's why many people will do better with potentially higher-return investments like stocks to keep pace with rising tuition costs. The good news: Because savings bonds are typically purchased by the parents (or those who are least 24 years old or older), they usually have little effect on how much aid you'll get.
We think Savings Bonds as a College Planning tool get an “F”
Taxable Accounts
By investing money for your children in a regular brokerage account, you will have greater control, unlimited investment options, and the flexibility to use the money for any purpose. Plus, the new tax law, which cut the top tax rate on capital gains and dividends to 15%, makes the tax bite less onerous. Like savings bonds and 529 savings plans in the parents' names, taxable accounts have little effect on how much financial aid you'll get. So don’t rule these out! But beware of the brokerage fees!
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