When it comes to paying for college, students and their families have a variety of savings plans at their disposal. But it’s important to choose the right one for your financial situation.

Last week we covered Series EE Bonds and Coverdell Education Savings Accounts. Now, we’ll tackle 529 plans, traditional IRAs and the Roth IRA.

The 529 Plan

A qualified tuition program (QTP) (also known as a 529 plan or program) is a program set up to allow you to either prepay or contribute to an account established for paying a student's qualified education expenses at an eligible educational institution. There is no tax deduction for the contribution, meaning the earnings are not taxed when withdrawn for college use.

Qualified educational expenses include tuition, fees, books, supplies and required equipment for enrollment or attendance at an eligible educational institution. Expenses also include the reasonable costs of room and board for a designated beneficiary who is at least a half-time student. Computers and computer software no longer qualify as qualified educational costs.

There are two types of 529 plans, prepaid tuition plans and college savings plans, and every state offers at least one of these types of plans. Some states offer both, and now a number of private colleges also offer a prepaid tuition plan.

 

Prepaid Tuition PlansCollege Savings Plans
Tuition and fees onlyTuition, fees, books, and supplies
Room and board usually not coveredRoom and board if at least half-time
Lock in current tuition ratesNot directly protected against tuition increases
Must be a resident of state offering planNot limited to specific school or even state
May  have age/grade limitsNo age/grade limits
No investment optionsMany investment options
Transferability limited for others schools to equivalent tuitionFully transferable to other schools
May be transferred to siblingsFully transferable to other family members
Refund usually limited to depositFull refundable

Although the IRS typically allows you to give no more than $13,000 a year to another person without imposing a federal gift tax, you can contribute up to $65,000 to a 529 plan in one year. A special 529 rule allows you to lump together five years of the allowable $13,000 annual gift-tax exclusion to jumpstart a 529 plan.

The part of a distribution representing the amount paid or contributed to a QTP does not have to be included in income, and the beneficiary generally does not have to include in income any earnings distributed from a QTP if the total distribution is less than or equal to adjusted qualified education expenses.

Anyone may contribute to a 529 plan, and there are no income limitations such as those that affect ESAs, Hope, Lifetime, etc. Some states offer special incentives as well.

Traditional IRA

Traditional IRAs are often overlooked, and actually presents many advantages over traditional college savings plans including deductible contributions. Let’s start by looking at the rules to set up an IRA for your child.

First, there is no minimum age to have an IRA, so if your child meets the second test, he or she can set up a traditional IRA. The second test says the child must have “earned income”. Earned income is commonly a W-2 from a job, but might include self- employment income from a business such as cutting grass, modeling, etc.  The W-2 usually doesn’t come up for most folks until the child is 14 or 15 and actually gets a job.

For small business owners however, another option exists. Hiring your child in your business in a true employment situation with job descriptions, time records, paychecks, etc. is allowed at any age. We have seen parents hire their infant children to appear as models or spokespersons in ads. In any event, the payment to the child for these services will also result in a W-2 as earned income for the child, thus also allowing an IRA contribution. “Mom and dad employers” can deduct the child’s wages as a business expense, and junior puts the money in an IRA to avoid tax. In fact, if mom or dad’s business is a small sole proprietorship (Schedule C), then both the child employee and the parents are exempt from paying payroll taxes on the child’s wages until the child is 18.

The child may deposit up to $5,000 in an IRA or their earned income, whichever is less, each year. The child then receives a tax deduction for the amount deposited. The deposit must be made by no later than April 15 of the following year (For 2011 a deposit may be made from Jan 1 through April 15, 2012).

When the child takes money out of the IRA to pay for college-related costs, the entire amount withdrawn is subject to income tax. However, because the child often does not have any other income, the tax could be non-existent or very low, particularly because the child may also receive in some cases education related deductions.

If the child withdraws money from the traditional IRA to pay for tuition, fees, books, supplies and equipment, and room and board is full-time, there is no penalty, even though the child is not retired. In addition, the use of the IRA money does not reduce the American Opportunity or Lifetime Learning credit qualified expenses! The expenses must be reduced by any scholarships, grants or other tax-free assistance received. The money must be spent on qualified expenses in the year of withdrawal. Finally, if the IRA is not used up for college, it is still an IRA that may be used to buy a first home without penalty or accumulate until retirement. And best of all, IRAs are not considered assets on college financial aid forms.

Roth IRA

Although the theory behind using a Roth IRA is similar to that of a traditional, deductible IRA, there are several differences. Contributions to a Roth IRA are not deductible, and withdrawals of principle are not taxable or penalized. If at least one Roth IRA has been open for at least five years, then the earnings may be used without penalty for education costs, although taxable income may occur if the earnings are withdrawn.

You must have earned income to set up a Roth IRA, but again there is no minimum age to establish a Roth. The deposit limit is the same as for the traditional deductible IRA. The Roth may not be transferred to other family members.

Bob Jennings is a CPA, EA and CFP and author of “Understanding Social Security & Medicare” His website is www.thecloudcpa.com and he can be followed on Twitter @Jenningsseminar