Tax-advantaged savings plans
Here are three popular tax-deferred education savings plans to consider:
- Coverdell Educational Savings Account (CESA)
You may set aside up to $2,000 a year in a CESA for a designated beneficiary under age 18 to pay for qualified expenses2 at an eligible educational institution, which can be either a qualified higher education or qualified elementary or secondary school.
Although the money you contribute is not tax-deductible, the savings within the account grows tax-deferred, and if the money you take out of the account is used for qualified educational expenses, it is tax-free. (See: Coverdell Education Savings Account to learn more)
These plans provide the opportunity to either pre-pay education costs or contribute to a tax-deferred savings account. Most 529 prepaid tuition plans are sponsored by state governments and require that you live in that state to be eligible.
Money contributed to a 529 savings plan is not deductible from your current federal taxable income, but earnings within the savings plan are tax-deferred, and some states may offer state tax benefits.
When you open a Prepaid Tuition Plan account, the money you contribute is converted to units or credits to be used for college and university education. When you open a Savings Plan, in addition to the contributions growing tax-deferred, they may be withdrawn tax-free if that money is used to cover eligible education costs for the beneficiary.
In addition, you may take up to $10,000 per year in tax-free withdrawals per beneficiary to pay for tuition expenses at private, public and religious K-12 schools. (See: How to choose a 529 Educational Savings Plan)
This may be a more flexible option for parents who aren’t sure how much they’ll be able to contribute to their children’s education without severely curtailing their own retirement savings plan. While the Roth is a form of an individual retirement account, you can use funds from it to cover your children’s qualified higher education expenses.
While you normally would face a 10% penalty for withdrawing investment earnings beyond your total contributions to use for your retirement needs prior to age 59½, there are no penalties if you use the money for your children’s qualified higher education expenses (although you would have to pay income tax on your investment gains).
You can open a Roth and start contributing at any time as long as you meet the income requirements.3 (Learn more about the Roth IRA)