Coverdell ESA

• The Coverdell ESA is a special savings account that allows you to contribute up to $2,000 a year toward college. You can invest money inside the account into stocks, bonds, mutual funds and similar financial securities. Your investments in the account are allowed to grow tax-free, much like your 401k plan or individual retirement account (IRA).
  
  

529 Plan Basics

• There are two types of 529 plans. The prepaid tuition plan allows you to buy college credits from participating universities, allowing you to lock in today's prices for classes you plan to take in the future. The college savings plan works much like the Coverdell ESA, which allows you to invest your college savings tax-free. The amount you can contribute to your 529 plan is set by the state you live in, but most states allow you to contribute significantly more per year than the $2,000 Coverdell limit.
  
  

Qualified Distributions

• You can withdraw money from your Coverdell ESA or 529 plans tax-free if you use the money to pay for college and related schooling expenses. In addition to tuition and related fees, you can use the money to pay for books required by your professors, equipment you need for school, such as your computer and even living expenses if you are a full time student.
  
  

Nonqualified Withdrawals

• If you withdraw money from your Coverdell ESA or your 529 plan and you do not have college-related expenses during the tax year, you may be required to pay a 10 percent tax penalty on the amount you withdraw. In addition, if your investments inside the account have earned money, you will have to pay capital gains tax on your investment gains. However, if your investments inside account plan have not earned money or lost money, you can avoid the 10 percent tax penalty and capital gains tax. In fact, you can deduct your investment losses for the year in which you took a withdrawal.