State-sponsored 529 college savings plans--many of which offer investment options similar to mutual funds--have become a lot harder to resist. As of Jan. 1, you can take money from these accounts free of federal taxes. Uncle Sam had previously taxed the account's earnings at your child's income-tax rate upon withdrawal.
These savings programs have become more flexible, too. You can switch investment options within the same plan once a year, says Joseph Hurley, founder of savingforcollege.com, which reports on 529 plans. To do so in the past, you had to roll over the account into a different state plan or change beneficiaries. If your child drops out, the list of kin to whom you can transfer the account now includes first cousins of the initial beneficiary. That's an important benefit for grandparents who establish accounts, says Judy Miller, principal at College Solutions, an Alameda (Calif.) financial consulting firm.
The Education IRA, renamed the Coverdell Education Savings Account after the late Senator Paul Coverdell (R-Ga.), has also been enhanced. Each child can receive a total of $2,000 a year--up from a measly $500--in these accounts, which grow tax-free and can be invested in any vehicle you choose. Unlike 529 plans, Coverdells can now be used for elementary and secondary school costs, including books, tuition, and tutoring. And more families can set up Coverdells, thanks to higher income limits. A married couple can contribute the full $2,000 if its adjusted gross income, or income before itemized deductions, is $190,000 or less, up from $160,000 in 2001 (table). If you choose to, you can now fund an Education IRA and a 529 in the same year. In the past, those who did so paid a 6% excise tax on the Education IRA contribution, says Andrew Gibson, a partner at accountants BDO Seidman in Atlanta.
The beneficial tax changes extend to those repaying student loans. The income ceiling on claiming at least some of the $2,500 deduction for interest payments is $130,000, if married, and $65,000, if single--up from $75,000 and $55,000. The time limit on such deductions, which was 60 months, has been dropped. And you don't have to itemize your return to take this deduction, which makes the benefit accessible to those with simple returns, says Jim Seidel, senior manager at RIA, a New York provider of tax information to accountants.
This year also marks the debut of a deduction for up to $3,000 of higher-education tuition bills for you, your spouse, or child. That rises to $4,000 in 2004, before ending in 2006. Married couples earning less than $130,000 qualify, as do singles with income below $65,000. (In 2004 and 2005, couples earning between $130,000 and $160,000 and singles making from $65,000 to $80,000 can deduct a more modest $2,000.) Keep in mind that you can't deduct tuition paid with Coverdell money or 529 earnings, says Hurley. So, as with all the items in this smorgasbord of options, be sure to crunch the numbers before deciding which is the right way to go. By Anne Tergesen