However, there is a noteworthy fly in the ointment here. The Pension Protection Act of 2006, which permanently made withdrawals of earnings from 529 plans free of federal taxes if used for qualified college expenses, failed to similarly extend some key provisions pertaining to Coverdells. The tax treatment of Coverdell earnings is not in jeopardy; however, as it stands now, the contribution limit to Coverdells will decrease from $2,000 to $500 after 2010. In addition, Coverdell withdrawals for elementary or secondary school expenses would no longer be allowed. But even if these provisions aren't extended, the worst-case scenario is that Coverdell owners would end up rolling their accounts into 529 plans. So at this point, the combination of tax-free savings and the ability to choose your own investments still make Coverdells a solid choice, as long as you realize you may have to switch courses in a few years.
• Roth IRAs. Although Roth IRAs are designed for retirement, they can be surprisingly useful for college planning as well. While you won't get tax-free treatment on earnings saved in a Roth (if used for college), you can withdraw your contributions for college expenses without tax or penalty. Ideally, you'll leave any earnings in the Roth for your retirement while withdrawing the principal to pay college bills. In addition, if junior doesn't go to college, gets a scholarship, or whatever, there's no need to move your savings around to a different type of account if it's already in a Roth IRA. It's already in the most tax-advantaged spot for your retirement savings to be. This can be a big benefit, since the annual Roth contribution limits would likely keep you from being able to transfer large sums from a college-specific account into a Roth down the road. And if you're fortunate enough to be making big bucks by the time the kids go to college, you can pay some college bills out of current income and keep more of your Roth IRA intact (since you may no longer be eligible to make new contributions to a Roth due to your high income).
With the 2007 annual limit for Roth IRAs at $4,000 and increasing to $5,000 in 2008, a married couple will be able to save a full $8,000-$10,000 per year in Roth IRAs. Many families with kids aren't going to be able to save more than that anyway, and if they can, Coverdell accounts and 529 plans are still available.
Unfortunately, there is a potential downside to using a Roth IRA to save for college, and that has to do with how IRAs are treated in the financial aid formulas. These formulas consider family income as well as assets. A parent's IRA isn't counted as an asset in the formulas, but withdrawals from IRAs often are counted as income. In other words, withdrawals from a Roth to pay college expenses are likely to bump up current income in the formulas, potentially decreasing your aid eligibility. Coverdell ESAs and Section 529 plans get the opposite treatment—they count relatively lightly against you as parental assets, but withdrawals normally don't count against you as income. As a result, if you think you're likely to qualify for financial aid, saving for college via a Coverdell ESA or Section 529 plan may be a better choice than doing so via a Roth.
The tradeoff is that a primary reason to consider a Roth for college savings in the first place is that bumps in the financial road do happen sometimes. If it comes down to an either/or situation, it's more important that you have a reasonable level of retirement savings than a large college savings fund. Remember, no one will lend you money for retirement; however, they will lend your child money for college.
• Section 529 plans. These plans have become the savings vehicle of choice for many parents and grandparents. A 529 plan offers the same potential tax-free savings for college as a Coverdell ESA. Most 529 plans are run by individual states, the majority of which make their plans available to any U.S. resident (rather than just residents of their state). This means a great variety of plans are available to today's college saver. Students are not required to attend college in the state where their 529 plan money is invested either; they can use the assets at any accredited post-secondary institution in the U.S.
