Coverdells are qualified investment accounts that allow nondeductible contributions of up to $2,000 annually per beneficiary. Earnings in the account are not taxed; and as long as withdrawals are used for qualified education expenses, they are tax free as well. Assets in a Coverdell must be used before the beneficiary's 30th birthday.
Keep in mind that the designated beneficiary of a Coverdell account is free to take withdrawals at any time, but any amount in excess of his or her qualified education expenses will be taxable as income. A 10% additional federal tax may also apply.
Coverdells also have a special feature unavailable with 529 plans:
- Qualified withdrawals may be used to pay for an elementary, secondary, or college education. Withdrawals from 529 plans can only be used for college expenses.
- Unlike 529 plans, Coverdells impose income eligibility limits on contributors. Single filers with modified adjusted gross incomes of more than $110,000 and joint filers with incomes of more than $220,000 cannot contribute.
Custodial accounts: UGMA/UTMA
The Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) -- each state uses one or the other -- allows adults such as parents and grandparents to establish and contribute to a custodial account in a minor's name without having to establish a trust or name a legal guardian.
Contributing to an UGMA/UTMA account can accomplish two goals simultaneously:
- Helping a future student prepare for college costs and
- Reducing the value of a contributor's taxable estate.
Both UGMA and UTMA accounts offer favorable tax treatment of investment earnings.
It’s important to note that the assets in these account belong to the child, not to the contributor. The recipient is free to spend the money with no restrictions when they reach legal adulthood at age 18 or 21, depending on the state. Contributors cannot legally require the recipient to use the money for college costs.
U.S. Savings Bonds offer investors both a government guarantee of principal and interest and a significant income-tax shelter. The government currently issues two types of savings bonds: Series I and Series EE. They are sold in a selection of different denominations from $50 to $10,000, at an issue price that is a 50% discount to face value, and may be redeemed at any time after 6 or 12 months, depending on the issue date.
When used for gifts to a child, the child should be listed as the sole owner, with a parent or another child as beneficiary. A 1040 tax form needs to be filed for the child each year following the gift, declaring the annual accrued interest. No matter how much income a child reports from Series EE Bonds or other sources, the parents are still entitled to claim a dependency exemption if they provide over half of the total support for each tax year the child is under 19, the child is over 19 and a full-time student for at least five months, or the child does not claim an exemption on his or her tax return.