Consider four tax-smart ways to save for college

The cost of sending a child to college is daunting. According to the latest figures from the independent College Board, the total average cost for the 2010/2011 academic year – including tuition and fees, room and board, books and supplies, transportation and other sundries – for in-state students at four-year public colleges was $20,339. For out-of-state students, the average cost jumped to $32,329. The cost at four-year private colleges averaged $40,476. And costs are expected to keep rising.

Nevertheless, you can lighten the financial burden of putting your children through school by taking advantage of certain tax-favored vehicles. These techniques are generally available to grandparents as well as parents. Here are four prime examples.

1. Section 529 plans: There are two main types of Section 529 plans. With a “college savings plan,” you can make generous contributions to a special account established for a designated beneficiary. Every state offers its own versions of these plans. With the second type, you may arrange to pay future tuition costs in today’s dollars through a “prepaid tuition plan.”

Funds contributed to a Section 529 plan may accumulate without any current tax, and distributions are tax-free if the money is used to pay for qualified higher education expenses. When an older beneficiary (such as your first-born child or grandchild) graduates, you can transfer the remaining balance in the account to a younger beneficiary.

2. Custodial accounts: A custodial account established under controlling state law is a more traditional way to save for college. Typically, you create a bank account in a child’s name and manage the assets until he or she reaches the state-mandated age. The income is taxed at the child’s tax rate, which is usually lower than your rate. Caveat: Under the “kiddie tax,” unearned income above an annual threshold ($1,900 for 2011) received by a child under age 19, or a full-time student under age 24, is generally taxed at the top marginal tax rate of the parents.

3. Section 2503(c) trust: This type of trust (sometimes called a “minor’s trust”) avoids kiddie tax problems because the income it generates is taxed directly to the trust. Furthermore, unlike a custodial account, you can set up the trust to continue past the state age of majority, as long the child doesn’t exercise a limited right to withdraw the funds. The trust must comply with all the legal requirements.

4. Coverdell ESAs: The Coverdell Education Savings Account (ESA), initially dubbed the “Education IRA,” is essentially an IRA used to pay for education expenses. This type of account may be used for elementary and secondary school expenses as well as college. However, the annual contribution limit for Coverdell ESAs is only $2,000, as opposed to Section 529 limits usually reaching six figures. Also, eligibility is phased out for high-income taxpayers.

Contact us if you would like to determine the best approach for your situation.