Changes in the tax code last year greatly enhanced two options for moms and dads. The big improvements: a sharp increase -- from $500 to $2,000 a year -- in the amount you can save in a tax-advantaged Coverdell Education Savings Account, or ESA (formerly known as the Education IRA), and the exemption from federal taxes of qualified withdrawals from the state-sponsored college-savings plans known as 529s.
Which of these two makes the most sense for your family? It depends. According to experts:
Consider an Education Savings Account if... You might use the money to pay elementary or secondary private- or parochial-school tuition. ESAs permit penalty-free withdrawals to pay for kindergarten-through-12th-grade expenses (529s don't), as well as college and graduate-school bills. You want total control over your investments. ESAs allow you to invest your contributions any way you wish and change those investments as often as you like.
Consider a 529 plan if... You'd like professional help choosing your investments. Most 529s offer several professionally managed mutual-fund portfolios, based on either your child's age or your risk tolerance. You think you'll qualify for financial aid when your child is ready to go to college. Savings in a 529 aren't counted as heavily in financial-aid formulas as are assets in an ESA. You can afford to invest only a small amount. Some 529s require an initial investment of as little as $25. You want to invest more than the $2,000 a year ESAs allow. 529s don't restrict annual contributions (though total giving is often capped). You live in one of the 24 states that currently offer a state tax deduction for contributions to 529s (to find out if you do, visit savingforcollege.com). You may need the money someday. Unlike an ESA, which must be used for your child's education, 529s can be reclaimed by the account owner (who'll owe taxes and a penalty).
Contributing editor Diane Harris is coauthor of the women's personal-finance book It Takes Money, Honey.