Mark Berg used to save for his child's education in a Coverdell Education Savings Account, a tax-deferred investment account for saving for both early education and college.
But the account just didn't keep up with the rising cost of college, says the Illinois-based financial planner. At the time, Coverdell accounts were limited to $500 annual contributions, totaling $9,000 in maximum contributions.
But now that the annual deposit limit for Coverdell accounts has increased to $2,000, Berg's feelings have changed. The accounts offer more flexibility in investment choices than 529 plans, another type of tax-advantaged college savings accounts.
"If you're not going to be able to contribute more than $2,000, the Coverdell makes all kinds of sense," he says.
In rare circumstances, Roth IRAs can also make sense for parents who aren't sure if their children will go to college, Berg says. Money can be withdrawn from individual retirement accounts for education tax-free, but parents can use the money for their own retirement if their child doesn't end up going to college.
[Take these steps before opening a college savings account.]
While 529 plan investment choices are limited to a selection of investment choices dictated by the state, Coverdell accounts and IRAs aren't, Berg says. Account owners can choose any and as many investments as they want, from stocks to bonds and money markets.
In addition, changes in investments can be made more than once per year, which comes in handy during rises and falls in the stock market, Berg says.
For instance, when the market fell in 2008, most mutual funds containing stocks lost some cash value. In that situation, it would make sense to sell some bonds to buy stocks or stock-market based mutual funds while prices are still low.
Trying to react once a year can be like trying to buy items you saw at an after-Christmas sale in February. "They're just no longer on the shelf," he says.
[Discover ways to save on college costs.]
A major difference between 529 plans, Coverdell Education Savings Accounts and retirement accounts are the annual contribution limits for each kind of account. The limits for 529 plans are based on the amount states deem necessary for a student's future qualified education expenses, while Coverdells are capped at $2,000 in annual contributions.
Another difference between the types of accounts is that there are income limits for tax-free contributions to Coverdell Education Savings Accounts, which don't apply to 529 plan accounts. Married couples filing joint federal taxes can't get a tax break on contributions if their combined income tops $220,000, while taxpayers with other filing statuses can't contribute tax-free if their income is above $110,000, says Ernie Almonte, a Rhode Island-based personal financial specialist and certified public accountant.
The accounts also differ in what levels of education they can be used to pay for. Coverdell accounts give parents the flexibility to pay for either primary or higher education. That makes the accounts, in conjunction with a 529 plan, useful for parents sending their children to private schools before they go to college, experts say.
Like Coverdell accounts, Roth IRA contributions are capped. Account holders less than 50 years old are currently limited to $5,500 per year, while those ages 50 and older can contribute $6,500 per year, according to the IRS.
Any IRA is technically supposed to be used as a retirement account, but there is an exception that allows account holders to withdraw money for higher education. But the money in that account has to cover retirement, too.
The federal tax rules state that withdrawals for qualified higher education expenses, such as tuition and textbooks, are not subject to the 10 percent additional tax on early withdrawals from retirement accounts. However, the money must be withdrawn for the education of immediate family members: parents or their children.
"I try to encourage clients to keep IRAs for retirement purposes," says Almonte, who used 529 plans to save for college for all five of his sons. "There are loans for college expenses but there are not many loan options for retirement."