Dolan Warning: Pay Attention to Those Taxes!

As we mentioned, one of the biggest attractions of 529s is that the earnings grow tax-sheltered–but you need to know what the state income tax consequences will be before you decide upon a particular plan.

At the federal level, everyone is covered. Earnings are not subject to federal taxes as long as you keep the money in the account, and withdrawals are exempt as long as you use the money for qualified educational expenses.

However, state laws about tax exemption vary from one state to another, so be sure to find out the particulars for any 529 plan you're considering.

Here's the potential horror tale: If you live in a state that doesn't tax the earnings and buy a national plan from a well-known financial firm, you may be buying a plan that is administered in another state and doesn't give you the favorable state tax treatment you should get–meaning you're losing money that could be earning compounded returns while your child grows up. You might choose the plan offered by a firm, but it's actually sponsored by a particular state with investments that may generate tax deductions only for residents of that state.

On the other hand, if you live in a state that allows state income tax exemptions for withdrawals from both in-state and out-of-state plans (currently Kansas, Maine, Pennsylvania and, in 2008, Arizona)and doesn't allow a deduction for the contributions, you can invest in any plan and still get all of the favorable tax treatment allowable.

#2: The Coverdell Education Savings Account (ESA)

The coverdell Education Saving Account, or ESA, is named after the late Georgia Republican Senator Paul Coverdell, who fought tirelessly for this measure. Formerly known as an Education IRA, a Coverdell is indeed much like an IRA in that you invest money that grows tax-deferred but, as with a 529, the withdrawals are tax-free if you use the money for the educational expenses defined in the plan.
A Coverdell is similar to a 529 in many ways, but there are a few important differences you need to know about. Let's start with the two biggest advantages:

• With a Coverdell you are able to choose your own investments, while 529s have more-limited choices.
• You can make tax-free withdrawals from a Coverdell to pay for elementary and high school expenses– tuition, room and board, uniforms, tutoring, computer equipment, and almost anything else you can name - while 529s are designed to be used only for higher education expenses.

And now for the downside: You can't contribute nearly as much to a Coverdell as you can to a 529 account. Much like an IRA, the maximum annual contribution to a Coverdell is $2,000. Also, there is an income ceiling on the Coverdell. If you're married and filing jointly, you can't make more than $220,000. For singles, the limit is $95,000.

Because the 529 plans have fewer restrictions, they are much more popular, with over $50 billion currently invested in them.

For more specifics on 529s, Coverdells, various state plans, and more, we recommend a great Web site: www.savingforcollege.com. You can even get a consultant at the site.

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