The Differences Between 529s And Coverdell ESAs

By: Eva Sadej

The cost of college has risen 8% every year since 1970 [1]. If we assume this same rate of increase over the next ten years, then a college education that costs $30,000 per year in tuition today would cost $62,991 in. The rapid increase in the price of college education makes it imperative to save as much money as possible for your children’s college educations, as soon as possible, and to ensure that your money works as hard as it can, with only the minimum going to the government in taxes.

There are two tax-free ways to save money for your child’s college education: a 529 plan or a Coverdell Education Savings Account. It’s worth noting there’s two different categories of 529 plans: one category that involves prepaying for tuition at today’s levels and another that involves a portfolio of stocks, bonds, mutual funds, and fund-of-funds responding to market up and down swings. Though not the only difference between the two categories of 529 plans, it’s an important and obvious distinction to make in terms of risk and reward. Each state has as least one 529 plan, but some may have more plans (Colorado, for example, has 5 plans). In addition, you are not limited to just the plans offered by your state; the majority of state plans are open to non-residents. It may behoove you to shop around.

All three college savings plans – prepaid 529s, portfolio-based 529s, and Coverdells– qualify for tax-free disbursements for qualified expenses. However, each type of plan has a different definition for what qualifies as a «qualified expense».. In the case of a 529 prepaid plan, the range of expenses that are considered qualified expenses is quite narrow. A prepaid 529 will typically only go toward tuition and fees, whereas Coverdell ESAs and 529 savings plans both can be used for tuition, fees, room, board, books, laptops, and other expenses at qualified institutions. All three types of college savings plans can be used for K-12 expenses, college, and graduate school, although some states limit 529 prepaid and portfolio-based plans to undergraduate education only.

In addition, one benefit that both types of 529 plans have over the Coverdell ESA is that some states allow contributions to a 529 plan to be tax-deductible on the state level. You don’t have that opportunity with a Coverdell ESA. And although the Coverdell ESA does offer you more control over where your money is invested—since it’s a brokerage account rather than an administrated mutual fund like a 529 plan, your investment choices are effectively limitless —your yearly contributions to the plan is limited to only $2,000. This contribution limit can be truncated even further, going so low as zero depending on income level: if you make an adjusted gross income of $110,000 and are a single filer, you are over the threshold to contribute even a dime ($220,000 if you are filing jointly).

With a 529 college savings plan, your contribution limit gift-tax free is up to $13,000 a year (or $26,000 if you are joint filer) and you can contribute as much as you want over this amount (though contributions over $13,000 are subject to gift tax) until the account total per beneficiary hits the neighborhood of $350,000 from all sources. (This limit is placed so that people don’t hide away funds for retirement or other goals inside an account designed to be used for educational expenses.) This is a massive difference if you want to plan ahead for years of undergraduate and graduate school education for your child. Also, there is no income threshold for either prepaid or portfolio-based 529 plans, so if you are within the income limits of a Coverdell ESA but would like to save even more, it is best to open a 529 portfolio or prepaid plan.

Another concern is when, if ever, the beneficiary can directly access the account. The money in a Coverdell ESA becomes the beneficiary’s property when they turn 18, regardless of whether they attend college or not. You cannot contribute to a Coverdell ESA if the student is over 18 years old, and beneficiaries cannot be switched in the event college no longer becomes an option. The student then has to use all the funds by the time they turn 30 or incur a penalty. With a 529 plan, the account remains the property of the creator, no matter whether the student attends college or not. Also, the time-frame for using money in a 529 plan varies from state to state, and most importantly, plan ownership can be transferred to another family member or a first cousin if desired or necessary.

One final concern is whether or not grandparents will be contributing. A student can have multiple Coverdell ESA accounts as long as the cumulative contribution that year does not surpass $2,000. Grandparents cannot retain the same degree of control over an ESA account as a 529 plan. Most ESA’s require that the contributor be the child’s parent or legal guardian, and the ones that do allow grandparents to open an account and contribute do not allow them to withdraw money in the case of a medical or other emergency, since it is held, much like a trust, under the student’s social security number. And if you miscoordinate who will be contributing this year (say you as the parent contribute and then your child’s grandparents contributes and the contribution this year is now over $2,000) you may incur a fee. 529 plans, on the other hand, have no absolute contribution cap and multiple accounts can be opened and withdrawn from if necessary, as long as the cumulative total balance of all the accounts does not surpass the neighborhood of $350,000 (this value varies by state). Furthermore, grandparental assets are not counted in the formula to calculate a student’s financial aid award.

If you want control over where your money goes, and your income is below the guidelines, then a Coverdell ESA allows you some of the financial flexibility you need to secure your child’s future. However, you won’t be doing much securing with a contribution cap of just $2,000 a year. If you are not the only one putting money toward your child’s education, or if you want to contribute significantly more than $40,000 over your child’s lifetime, a 529 savings plan will serve you better. Undecided? You always have the option of opening both if you qualify, and their contribution caps are not related: if you have surpassed the maximum contribution this year to a Coverdell ESA in the student’s name, you can still open a 529 plan.

[1] https://www.finaid.org/savings/tuition-inflation.phtml

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