Q. My husband and I just had our first child. My parents invested $1,400 in a CESA mutual fund for him. They’ve promised to do it every year if my husband and I add $50 per month. We can afford it but don’t know if it’s a good idea. What do you think? – Serena B.
A. Your parents have come up with a great way to motivate you to save for your son’s college education. In effect, they’re offering to make matching contributions. For every $1 you contribute, they’ll contribute $2.33, which is hard to turn down. So I recommend thanking your parents and start doing your part. Here’s why.
In 2010, the cost of tuition, room and board at many public colleges is pushing $20,000 per year. By the time your son is ready to enroll, it will be $57,000 per year, assuming 6 percent inflation in the cost of college. That is a lot of money. In fact, after buying a home, educating your son is likely to be the biggest expense you and your husband will face.
A CESA mutual fund is a Coverdell Education Savings Account. In several ways it’s similar to a Roth IRA. Your contributions are not tax deductible, but your earnings grow 100 percent tax-deferred. Importantly, withdrawals are tax-free if used to pay for qualified educational expenses.
Married couples may contribute up to $2,000 per year to a child’s CESA if their modified adjusted gross income is less than $190,000 ($95,000 for single taxpayers). Phase-outs apply to those with higher incomes. If your parents invest $1,400 annually and you invest $50 monthly, that puts you at $2,000, the most that can be contributed for your son in a single year.
A CESA is essentially an empty bucket. When you put money in the bucket, you can choose how to invest it. For example, you might choose bank CDs or mutual funds. Your parents have chosen mutual funds. If they earn 8 percent from now until your son starts college, his CESA will grow to $76,434. Although this won’t cover the entire cost, it’s a terrific start.
Whenever possible, I like using CESAs as the foundation layer of a college savings plan. They’re easy to understand and offer a broader definition of qualified education expense than 529 plans. Specifically, you can withdraw money to pay for primary and secondary education (K-12), as well as college or graduate school. Also, you can withdraw money to pay for tuition, room and board, computers, books, supplies, tutoring and transportation.
Although it’s hard to believe, some children finish school with money left in their CESAs. If this money is not rolled over into a CESA for a related party (a sister, brother or cousin) under 30 years old, it must be distributed by the child’s 30th birthday.
You can find out more about CESAs and other ways to pay for college by visiting collegesavings.about.com.