Education Savings Plan No. 1

Savings bonds

Purchase U.S. Savings Bonds (Series EE issued after 1989 or Series I).  You can exclude all of the interest income that accrues on these bonds if you, as the parent of your child:

• Pay qualified higher education expenses (tuition and fees) in the year of redemption,  
• You do not file your tax return as married-filing-separately, and
• Your income is not too high.

The bonds must be in the your name, not in the name of your child.

You must buy the bonds, not a relative or family friend.

Once your child is in college, you can’t claim an exemption for any bonds that exceed the cost of the education.  For example, if that year’s educational costs total $10,000, that’s the most you can cash in and declare exempt for taxes.  To avoid this problem, buy bonds in increments you expect will not exceed the annual costs of education.

Education Savings Plan No. 2

Regular Investment Account

In General -- Invest money in the name and social security number of your child.  Investment income of children is taxed at lower rates (within limits).  Investment income is interest, dividends, capital gains and losses, royalties and rent.  The child's tax rate depends upon their age.

Dependent Children under age 18 -- The first $850 of investment income is tax-free.  The next $850 is taxed at 10%.  Investment income after this is taxed at the parent's marginal tax rate (this is known as the "kiddie tax").  If your child owes a tax you may be able to report it on your tax return without filing a tax return for the child.  To see if you qualify to report your child's income on your tax return see the instructions to Form 8814. 

Dependent Children age 18 and older -- The first $850 of investment income is tax-free.  The next $7,300 is taxed at 10%, and so on according to the tax rates for single individuals.  The "kiddie tax" does not apply.  If a tax is due, the child will need to file a tax return.

Conclusion -- If you begin early, your child will be able to accumulate a sizable sum of money tax-free, or at very low rates.  These funds are then available to pay for education costs, or for any other purpose for that matter.

Education Savings Plan No. 3

Coverdell Education Savings Account

Contribute up to $2,000 per year to a Coverdell Education Savings Account (ESA) for beneficiaries under age 18 (and special needs beneficiaries of any age).  These accounts were formerly known as an Education IRAs.

Earnings in these accounts are not taxed if withdrawals are used for education purposes.

Anyone, including Grandparents, can put money into these accounts.  However, not more than $2,000 can be put into the account of any one child for any one year.

If you are married and filing a joint return the $2,000 limit is phased out for income levels between $190,000 and $220,000.  For all others the phase out is for income levels between $95,000 and $110,000.

Just because the parents cannot make a contribution because their income level has phased them out, doesn't mean that the grandparents or someone else is not eligible to make a contribution.

Education Savings Plan No. 4

529 Plan

In General -- Contribute to a state sponsored Qualified Tuition Program (QTP), or eligible educational institution sponsored QTP.  There are two types of 529 Plans--a prepaid tuition plan and a savings plan.

Under the Prepaid Plan -- a parent, grandparent, or other qualifying taxpayer purchases tuition credits to lock in current rates.  The credits are used later when the student starts college.

Under the Savings Plan -- an account is set up and funded each year.  The account grows tax-free and funds are withdrawn tax-free when the student begins college.  Large sums of money can be put into these plans.  Taxpayers wanting to gift out of their estate to fund the savings plan may do so for an amount up to $55,000 for the current year and avoid gift tax.  Broker fees and plan expenses may be assessed.

Other Rules -- The federal government places some limitations on these plans (see table below).  States that sponsor these plans have additional limitations that vary from state to state.