What's the Best College Savings Account?

By Wendy Connick Markets Fool.com

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If you have kids or grandkids, you're probably hoping they'll go to college one day. Of course, given the rate at which college tuition and fees continue to rise, you may also be wondering how on Earth you'll be able to pay for it. Socking money away while the kids are still tiny can make the difference between an affordable degree and a mountain of student loan debt that your child could be paying off for decades.

Fortunately, various schools and government agencies have done their best to come up with ways to help Americans save for educational expenses.

529 plans

Possibly the best-known education savings program today, the 529 plan is a program sponsored by a state government or educational institution to provide a tax-advantaged education savings account. There are tons of 529 plans out there, with different rates, fees, options, and rules, so prepare to do some serious shopping around. Note that you can sign up for a state's 529 plan whether or not you live in that state. Some states offer tax breaks to residents who use their in-state plan, but the incentives of other states' plans may outweigh that benefit.

Anyone can set up a 529 plan. The biggest benefit of these plans is that earnings are not subject to federal taxes and are usually not subject to state taxes, either. Withdrawals from the account are also tax-free when they're used to cover qualifying educational expenses. However, contributions aren't tax-deductible. There are no specific contribution limits, but if your contributions exceed $14,000 per recipient per year, you may be subject to gift tax.

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Inevitably, 529 plans come with some drawbacks, the biggest of which is the potential impact on financial aid availability. In brief, if a student has a 529 plan in his or her name, then financial aid providers will take those funds into account when determining the student's eligibility and level of need.

Coverdell education savings account (ESA)

If your modified adjusted gross income is under $110,000 per year ($220,000 per year for married-filing-jointly taxpayers), then you're eligible to open a Coverdell ESA. These accounts are set up with a trustee for a beneficiary under the age of 18 with the purpose of paying for said beneficiary's education. Anyone under the modified adjusted gross income limit can contribute to the Coverdell ESA, but total contributions for a given beneficiary from all sources are limited to $2,000 per year. Distributions are tax-free as long as they're used to pay for the beneficiary's educational expenses.

Coverdell ESAs are typically set up in the parent's name, so they don't have the same impact on financial aid that many 529 plans do. Financial aid providers do look at parental assets, but these don't impact eligibility as much as assets in the student's own name. The account must be emptied by the time the beneficiary hits age 30, or the remaining funds will be subject to taxes and penalties.

Savings bonds

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If you use your Series I or EE savings bonds to pay qualified educational expenses for yourself or a dependent, the bonds' earnings are exempt from federal taxes. Qualified expenses include tuition and fees for any college or university that's eligible to participate in the Department of Education's student aid program (which is practically every college and university in the U.S., and some foreign institutions as well). If you cash out your bonds to make a Coverdell ESA contribution, you also get the tax break.

The drawback to savings bonds is their lackluster rate of return; in early 2017, rates for series I bonds are at 2.76%, and series EE bonds return a depressing 0.1%. That's considerably less than you're likely to get from the investments in a 529 plan or Coverdell ESA.

All of the above?

Diversification is the key to any investment plan, and building a college savings fund is no exception. You can spread out the benefits and drawbacks of the various options by putting a little money in each. If the stock investments in your 529 plan bottom out at the wrong time, your savings bonds can help make up the difference, whereas the funds in your Coverdell ESA slide under the financial-aid radar. And since 529 plans are typically limited to conservative investment options, you can put some of that Coverdell money into more aggressive investments to try to kick up your overall rate of return. Think of it as a savings buffet: The more options you have lined up, the more likely it is that one of them will be particularly tasty.

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