• A Uniform Gifts to Minors Act (UGMA/UTMA) account. This college savings vehicle allows some taxes on investment gains to be paid at the child's lower tax rate. But with new account types available that offer truly tax-free savings, UGMA accounts have fallen out of favor. Some financial planners still like them because of their flexibility - the eventual use of the funds in the account is not restricted to paying for a college education. But that flexibility has a major drawback because it means essentially giving the money to the child outright. Once money is put into this account, the parent has permanently given up ownership. That means when Junior turns 18 or 21 (depending on your state of residence), it's his call whether he uses the money in the account to buy a Corvette instead of going to college.
• State-sponsored prepaid tuition plans. In general, prepaid state tuition plans promise that your investment in the plan today will cover tuition at any school in the state no matter what the cost at the time your child enrolls. Consider this recent example from Florida's College Prepaid Program: For the enrollment period that just ended, a lump sum payment of $13,409 for a child in the third grade would cover all of the child's future tuition and fees for four years at a state university - guaranteed. The price is locked in regardless of future increases in state tuition.
Due to the rapid rise of college costs in recent years, some states have either stopped accepting new participants in their prepaid tuition plans, or have made the pricing options less attractive. As a result, fewer parents have access to a compelling prepaid tuition plan. Still, they offer a no-risk alternative to paying for a college education. However, as with most no-risk investments, the internal rate of return typically isn't that great. In addition, there are some limits on how flexible these plans are. If Junior decides to break a five generation tradition and forsake Home State U. (gasp!) in favor of its arch rival in the state next door, the consequences vary from state to state. They may be as dire as having the amount contributed to the plan returned with very little interest, or your state might be generous and give a credit equivalent to what would be paid to an in-state school.
• Coverdell Education Savings Account. Created in 1997 as Education IRAs, and improved dramatically in 2001, Coverdell ESAs are a very compelling savings vehicle for parents who meet the contribution limits. Parents filing jointly with adjusted gross income below $220,000 may contribute up to $2,000 per child, per year, to a Coverdell ESA. The contribution is not deductible, but all earnings grow tax-deferred, to be distributed tax-free if used to pay the beneficiary's college expenses. $2,000 per year may not seem like much, but it adds up if you start early. Contributing $2,000 per year for 18 years with an earnings rate of 10% would accumulate to just over $100,000.
While both Coverdell ESAs and Section 529 plans offer the prospect of potentially tax-free earnings, Coverdell's offer the flexibility to choose the specific investments you desire. Section 529 plans don't, as we'll see shortly. This is a big advantage to using a Coverdell for those who want to direct their own investment program, as many Sound Mind Investing readers no doubt would want to do. (Most fund companies or brokerages can set up a Coverdell ESA for you, allowing you access to their full range of investment products.)
In addition, the favored tax treatment of Coverdell earnings extend to cover elementary and secondary school expenses. The list of qualified expenses is lengthy, and includes both obvious items like tuition and books, as well as non-obvious items like uniforms, transportation, even computers and Internet access for the family during the years the beneficiary is in school.
