While college fund accounts can offer tax benefits, the Internal Revenue Service only offers tax credits and deductions when your child uses money from such funds to pay for educational expenses. Certain college funds offer tax-deferred earnings and tax-free distributions when money is used to pay for college expenses. Each type of fund has its own drawbacks and advantages and IRS rules can change annually. State tax treatment of college funds can vary from state to state.
States and educational institutions sponsor 529 plans, also referred to as a qualified tuition plans. The IRS does not levy taxes on the earnings of 529 plans as long as funds withdrawn are used to pay for college expenses, such as on-campus housing and tuition. If your child uses funds for purposes other than college expenses, the IRS will levy taxes on withdrawals at his regular income-tax rate. Under such circumstances, his withdrawals may also be subject to a 10 percent penalty on earnings, as of the 2010 tax year.
Coverdell Education Savings Accounts
Coverdell Education Savings Accounts, also referred to as Educational IRAs, allow you to make contributions until your child reaches the age of 18. You can open a Coverdell ESA to pay for college expenses for children under the age of 18 or to arrange for the needs of a special-needs family member. Typically, the beneficiary of a Coverdell ESA becomes the owner of the account upon turning 18 years old. Earnings on Coverdell ESAs are tax-deferred and the IRS allows your child to make tax-free withdrawals to pay for qualified college expenses, such as tuition and school fees, up to the age of 30. If she uses funds for purposes other than qualified expenses, she must pay taxes on earnings at her regular income-tax rate and face a 10 percent penalty, as of the 2010 tax year. The same rule also applies to withdrawals made after she turns 30 years old.
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After the passage of the Uniform Transfers to Minors Act and Uniform Gift to Minors Act, financial institutions began offering custodial accounts, typically referred to as UTMA/UGMA accounts. These types of accounts allow you to gift money to your children, while avoiding gift and lifetime estate taxes on contributions that meet certain limits. UTMA/UGMA accounts allow you to remain custodian of the funds until your child becomes an adult. However, if you start a custodial account, your child faces tax liabilities, even as a minor.
Educational Tax Deductions and Credits
In certain cases, your child may be able to qualify for tax credits or deductions after withdrawing money from a college fund. For example, if your child receives college funding through a Coverdell ESA, he may qualify for the IRS's lifetime learning credits program, which can lower his federal tax liability. The tuition and fees deduction program may also allow him to deduct up to $4,000, as of the 2010 tax year. If he receives additional funds for school through a student loan program, he may also qualify for a loan interest tax deduction when he begins to repay the loan.
- U.S. Securities and Exchange Commission: An Introduction to 529 Plans
- Kiplinger; The Best 529 College-Savings Plans; Thomas M. Anderson; August 2007
- New York Life: Start a College Fund-8 Strategies
- IRS: Coverdell Education Savings Accounts
- American Century Investments: Details on UGMA/UTMA Accounts
- IRS: Tax Benefits for Education
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