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Tax-Advantaged College Savings Strategies

You're ready to start saving for college, but where should you put your money? There are many college savings options, but you should generally opt for tax-advantaged strategies whenever possible.

Why is it so important to consider strategies that offer tax benefits? Because taxes can eat away at any money you might earn.

Following are some tax-advantaged savings options to consider.

529 plans

A 529 plan, sometimes called a qualified tuition program, offers federal, and often state, tax advantages if used to save for college. There are two types of 529 plans--a college savings plan, which is an individual investment-type account, and a prepaid tuition plan, which is a pooled account that typically promises it will cover a certain percentage of college costs in the future.

With either type of 529 plan, contributions accumulate tax deferred at the federal level and earnings are completely tax free if used to pay the beneficiary's qualified education expenses. In addition, many states offer their own tax benefits, such as income tax deductions for contributions and tax-free withdrawals. If a withdrawal is used for a noneducational expense, the earnings portion of the withdrawal will be subject to federal income tax and a 10% federal penalty.

Investors should consider the investment objectives, risks, charges, expenses, and prerequisites for state tax benefits associated with each 529 plan before investing. More information is available in each 529 plan issuer's official statement, which should be read carefully before investing.

Coverdell education savings accounts

A Coverdell education savings account (ESA) lets you contribute up to $2,000 per year per child for a child's elementary, secondary, and/or college expenses. Like a 529 plan, contributions accumulate tax deferred at the federal level and earnings are tax free when used to pay the beneficiary's qualified education expenses. Similar to a 529 plan, if a withdrawal is for a noneducational expense, the earnings portion of the withdrawal will be subject to federal income tax and a 10% federal penalty.

However, only married couples with a modified adjusted gross income of $190,000 or less and individuals with an income of $95,000 or less can contribute the full $2,000 per year.

The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the annual contribution limit for Coverdell ESAs to $2,000 from $500 and expanded the use of funds to K-12. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended these provisions through 2012.

U.S. savings bonds

Series EE and Series I savings bonds offer a special tax benefit for college savers--the interest earned by the bonds is exempt from federal income tax if the bonds are used to pay college expenses. However, this benefit is restricted by income level. For 2011, to exclude all of the bond interest, married couples must have a modified adjusted gross income of $106,650 or less ($109,250 or less in 2012) at the time the bonds are redeemed (cashed in) and individuals must have an income of $71,100 or less ($72,850 or less in 2012). A partial exemption of interest is allowed for people with incomes slightly above these levels. Income levels are indexed for inflation each year.

The interest earned on U.S. savings bonds is always exempt from state income tax, no matter what your income level, even if the bonds aren't used to pay for college.

UTMA/UGMA custodial accounts

A custodial account allows you to hold assets in your child's name without having to set up a trust; these assets must then be used for the benefit of the child. A custodial account doesn't offer federal tax-deferred and tax-free earnings like a 529 plan or a Coverdell account, but it does provide some opportunity for tax savings due to the way earnings generated by the account are taxed.

Specifically, earnings are taxed to the child each year pursuant to the "kiddie tax" rules, and under these rules the first $950 of earnings is tax exempt and the next $950 is taxed at the child's rate (any earnings over $1,900 are taxed at the parent's rate). So, you'll have an opportunity for tax savings if the earnings in the account are $1,900 or less for the year.

A word about IRAs

Money you withdraw from a traditional IRA or Roth IRA to pay your child's qualified education expenses is not subject to the 10% premature distribution penalty tax that normally applies to taxable IRA distributions made before age 59½. However, some or all of the IRA money you withdraw may still be subject to regular federal and possibly state income tax.