My husband and I have been discussing investing money for our children’s college. As a military family, would a 529 college fund be appropriate for us? Isn’t that a state-run fund? Would a Coverdell account be any better for us? – Jennifer


I appreciate your viewpoint – there certainly is something to be said for kids having some “skin” in the education game. But, I also like your idea of putting money away to help out when the time comes. You know you’ll be tapped for some expenses. This is a big topic, so here goes. You mentioned two of the three main vehicles that come to mind when I think of socking money away for college: 529 College Savings Plan (529) and the Coverdell Education Savings Account (CESA). Either of these would work well, but let me cover several of the differences between the two plans and then explain a third option.

First, the CESA is currently limited to a $2,000 per year contribution for each child, whereas most 529 plans have total contribution limits in excess of $200,000 (gift taxes would have to be considered if funding the 529 plan above the annual gift tax exclusion of $13,000 in 2010). You can switch beneficiaries of either plan from one child to another, but ultimate control of the 529 reverts to you, the parent. With the Coverdell, when your child reaches age 30 the account reverts to them, the beneficiary. The CESA can be invested at your discretion in whatever mix of stocks, bonds and mutual funds you choose; the 529 plans typically have a menu of specific investment options, such as age-based options which morph into a more conservative mix as college approaches. Finally, the 529 can only be used for higher education, while the CESA could be used for elementary or secondary school expenses.

In either case, you could benefit from tax deferral and tax-free withdrawals for qualified education expenses*.

An important consideration is that there are 529 “savings” and “pre-paid tuition” plans. Savings plans, regardless of which state sponsors the plan, allows for funds to be used at virtually any school in the United States plus several international venues. The pre-paid plans are best used in the state with which they’re affiliated.

Even though you’re in the military, you may currently pay state income tax in your state of residency. If that is the case, setting up a 529 plan sponsored by your state may result in some state income tax savings, otherwise, you can choose most plans without regard for the state affiliation. Hopefully, that gives you enough ammunition to choose the plan that’s right for you.

The third option is to save in your name or set up a Uniform Transfer/Gift to Minors Account (UTMA/UGMA) in each child’s name. Saving in your own name would not provide any special tax benefit, but would give you the most flexibility. You could set up a jointly-owned mutual fund that you and your spouse earmark for educational expenses.

With an UTMA or UGMA you are actually giving the child a gift and investing it in their name. At your state’s age of majority the money becomes the property of the child—which some parents don’t like. After all, college may not sound appealing when you could buy a cool car with that money, right? Additionally, UTMA or UGMA funds count more against a financial aid application than the 529 plan or CESA do. Also, there are taxes to consider. The first $1,900 of investment income that a child earns is treated favorably, but beyond that any additional income (capital gains, dividends, interest) are taxed at the parent’s marginal rate.

You didn’t ask about it, but an important military family benefit is the Post 9/11 GI Bill. You sound savvy, so I figure you’re already taking the potential kid’s benefits into consideration.

Lots to think about.

*Tax-free earnings and withdrawals are for qualified educational expenses. Other withdrawals are subject to income tax and an additional 10 percent penalty on earnings. The availability of tax or other benefits may be contingent on meeting other requirements.