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How 529 Plans Work


Custodial Accounts and Coverdell ESAs
529 plans aren't your only weapon in the battle against mounting college expenses.
529 plans aren't your only weapon in the battle against mounting college expenses.
Ariel Skelley/Getty Images

529 plans aren't the only options for college savings. Custodial accounts and education IRAs are other ways you can set aside money for college expenses.

Money that goes into a custodial account is an irrevocable gift belonging to the child. The money out into the account lowers the family's total taxable income as long as the child's total income remains fairly low ($950 in 2012) and that income comes solely from interest. However, custodial accounts that earn significant amounts of money for the child (more than $1,900 in 2012) will be subject to taxation, which may eliminate their advantages. Other drawbacks include: the money has to be used for the child's benefit, not for your own or your family's (how much of a disadvantage this is depends on how likely it is that your own children will sue you over it); the child can spend the money on anything once he or she reaches either 18 or 21 depending on your state's age requirement; money in the child's name counts against the child's eligibility for financial aid. Money in a custodial account can be converted to a 529 plan, but the child still technically controls it [source: FINRA].

Congress improved Coverdell Education Savings Accounts significantly when Congress increased the annual contribution limit from $500 to $2,000 in 2002. Like 529 plans, ESA earnings are tax-free when used for education expenses, and they're considered the parents' asset so they don't adversely affect financial aid eligibility. They do have some advantages over 529 plans, including more control over your investments and the ability to use the money for private elementary or secondary school expenses.

People with higher incomes can't contribute to an ESA. For single tax payers, the eligibility phases out for incomes between $95,000 and $110,000. For married taxpayers filing jointly, eligibility phases out between $190,000 and $220,000. Another disadvantage is that the funds have to be used for education by the time the beneficiary turns 30. Like the 529, there is a 10-percent penalty if the money is used for anything other than education expenses [source: SavingForCollege].

For lots more information on saving money for college, explore the links on the next page.