There are numerous options available to invest savings for a child's education:
- State-sponsored "529" college savings plans: State-sponsored 529 plans are investment vehicles that allow you to make tax-free deposits for your child's future college costs. Depending on your plan you can either enroll directly through the state overseeing the plan or you may need to invest through a brokerage firm. You can choose between a variety of investment options for your funds according to your risk tolerance and investment time horizon (when you need to access those funds). Anyone can contribute to the plan (i.e. grandparents, extended family) and the earnings in the plan grow tax-free. You can then withdraw money tax-free from the account when it comes time to pay for school-related expenses. However if you use funds for non-college related expenses you will have to pay tax on the earning and a 10% penalty. If you're not satisfied with your plan's performance you can switch 529 plans once every 12 months. For more on this read, Don't Forget the Kids: Save for Their Education and Retirement and Choosing the Right Type of 529 Plan.
- Coverdell education savings accounts (ESA): You can contribute $2,000 each year (for each of your children) to a Coverdell ESA to help pay for your child's elementary, secondary school and college costs. You choose how your money is invested; the money you earn on your investment grows tax-free and you do not have to pay taxes when you withdraw money from the account for qualified education-related expenses. There are income limits to be able to qualify to contribute to a Coverdell ESA. ;Anyone whose income qualifies can contribute to an account (i.e. grandparents, family friends).
- Prepaid tuition plans: With a prepaid tuition plan you pay into an account either managed by a state or a specific college. Your funds are bundled with other contributors and invested to earn a return, which will hopefully outpace the rising cost of college tuition for the school or state which you have selected for your child to attend. As long as you withdraw money from the plan to pay for qualified school-related expenses your withdrawal is exempt from federal taxes and perhaps from state taxes as well. However if you withdraw the money for non-college related expenses the funds will be taxed and you will have to pay a 10% penalty on money your investment earned. And if your child chooses to attend a different school (if you're paying into a school-specific plan) or an out-of-state college (if you're paying into a state-managed plan) you may not be able to recover all of the money you have invested.
- Custodial accounts: The Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) accounts allow you to deposit up to $10,000 tax-free each year in an account to be used for your child's education. The account is in your child's name but managed by you until the child reaches 18 or 21 (depending on your state's law regarding the "age of majority"). While the child is a minor, money in the account(s) can be used for college or any other expenses for your child; however the account becomes the property of your child when s/he reaches the legal age of adulthood in your state and at that point can use the funds for any purpose, school or not.
- Series EE Savings Bonds:U.S. Treasury EE savings bonds are backed by the federal government and guarantee a fixed rate of return. Bonds can be redeemed to pay for qualified college expenses and the bondholder does not have to pay income tax on the interest earned. There are income limits to qualify for the tax exemption and the bondholder must be at least 24 years old. You are limited to purchasing $5,000 in EE bonds in one year; you can purchase EE bonds in a variety of denominations (between $50 and $10,000) and buy them online through the U.S. Treasury's Treasurydirect.gov website.
This question was answered by Katie Adams.