I just had my third son, the reality that I’ll be shipping my kids off to college sooner than later is sinking in. I had already started a 529 College Savings Plan for my first and will plan on doing another one for the second and now third.
Recently, I had a client in a similar boat and inquired about the difference between a Coverdell Education Savings Account vs. the 529 plan.
ESA’s (formerly known as the Education IRA) had been a popular planning tool for college up until the creation of the 529 plan and I very seldom ever come across them.
Actually, I have never opened one for a client and only hold a few for clients who have transferred them in from other institutions.
Let’s see if we can look at the differences between the Coverdell ESA and the 529 plan and see what might be best for you.
Similarities Between Coverdell ESA’s and 529 Plans
ESAs and 529 plans let you, the account owner, set up investment accounts for a beneficiary, or recipient, that you designate. This differs greatly from a custodial account where the child takes over at 18 and can do with the money whatever they want.
Go ahead and let your imagination run rampant here parents. Within these investment plans, your earnings and any capital gains accumulate tax-deferred, which means you put off paying taxes until your money is withdrawn.
And you can withdraw your money tax-free, or free of federal and sometimes state income taxes, as long as your beneficiary uses the money to pay for qualified education expenses, which may include tuition, books, fees, and room and board.
There is still some gray area on “qualified expenses” but items such as laptops and cellphones may qualify. Double check with your tax preparer to make sure.
How You Spend The Money
If you don’t spend the money on college-related expenses, prepare to get burned. Not only will you owe taxes on any earnings within the amount you withdraw, but you’ll have to pay the federal penalty—10% of your earnings.
Plus, certain states may impose an additional 10% penalty, bringing the potential fee as high as 20% of the amount you withdraw. Ouch!
Contributions to tax-free accounts must be made in cash. So rather than move investments you already own into the account, you would have to liquidate your assets and then deposit the money.
Doing so could trigger capital gains tax on any increase in value.
Keep It In the Family
One nice plus is that with both of these accounts you can switch the beneficiaries among other members of your family.
That includes the beneficiary’s spouse, child, grandchild, stepchild, sibling, step-sibling, parent, grandparent, stepparent, niece, nephew, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law—or any of these relatives’ spouses—as well as any first cousins.
This is also nice in case one child doesn’t use all their savings, You can then just transfer to the other child.
What about Gift Taxes?
When you contribute money to an account in another person’s name, your contribution is considered a gift.
You can give away up to $13,000 per year—or $65,000 once in five years to a 529 savings plan (as of 2010)—before you may have to file a gift tax report and eventually pay gift taxes. But gift taxes apply per donor and per beneficiary.
So, in one year you could contribute $13,000 to one child’s 529 account, and then contribute another $13,000 to another child’s account without owing gift taxes.
Or, you and other relatives could each contribute $13,000 a year to one child’s account. Remember, though, that ESAs limit contributions to $2,000 a year.
Differences between Education Savings Accounts and 529 Plans
The ESA and 529 have some key differences.
Here are the key three:
- In the ESA, the total contribution for any one beneficiary can be no more than $2,000 a year. You can contribute $2,000 to an eligible beneficiary’s ESA if you meet the adjusted gross income (AGI) requirements. That is, your AGI must be less than $110,000 if you’re single—or $220,000 if you’re married and filing a joint return. The 529 plan has no maximum contribution limit.
- In an ESA, as your AGI increases above these levels, the amount you can give is phased out until your AGI reaches $110,000—or $220,000 if you’re married—at which point you are no longer eligible to contribute. The 529 plans has no income restriction.
- Anyone who’s younger than 18 when an ESA is opened and younger than 30 when the money is spent is eligible to be a beneficiary. In a 529 plan, there are no age restrictions.
Coverdell Education Savings Accounts (ESA’s)
How it Works
You invest your account assets in any combination of assets available through the financial institution handling your account
- Accounts available in most banks, mutual fund companies, and credit unions
- Investment flexibility qualified withdrawals to cover grades K through 12, as well as college and graduate school
- Eligibility for making contributions phases out once AGI exceeds $110,000 (or $220,000 if you’re married and filing a joint return)
- Beneficiary must be under 18 to receive contributions
- Beneficiary can only accept $2,000 in contributions per year
- Beneficiary must make all withdrawals prior to turning 30
529 College Savings Plan
How it Works
You contribute to an account that’s typically invested in age- or risk-based investment tracks, which are provided by your plan manager.
- Over 100 plans available to choose from
- Contribution limits can run as high as $300,000 per account
- Beneficiaries can be named in multiple accounts
- Less investment flexibility due to investment tracks
- Some plans have higher than average fees that affect investment return
529 Prepaid Tuition Plan
How it Works
Your contributions purchase tuition credits at current rates, and the plan invests your contributions to meet future college costs.
- In many cases, investments are guaranteed to cover future tuition credits
- Qualified education expenses include only tuition and mandatory fees at participating colleges and universities
- Eligibility sometimes restricted by state residency requirements
Want to Switch from a Coverdell Into a 529?
You can do a rollover from a Coverdell ESA to a 529 plan without incurring any tax penalties as long as the 529 plan will have the same beneficiary as the present Coverdell account.
Earnings from a 529 plan can be distributed tax-free (assuming they are used for qualified education expenses). Contributions are taxed.
You can go one of two ways with a 529:
- You can prepay tuition at today’s rates (at a qualifying college or university) through a 529 prepaid tuition program.
- You can save to pay tomorrow’s college tuition through a 529 savings plan which gives you tax-deferred growth. Most people prefer this option for its flexibility and asset accumulation potential.
Time For School
When I considered how much I would have paid for school had I not joined the National Guard, I know it makes absolute sense to start early.
The beauty of these plans is that other family members and friends can contribute to these accounts or open additional accounts, as well.
We like to add a large portion of our son’s birthday money to his 529 plan. I know I’ll only get away with that for a few more years. 🙂
Before I know it, they’ll be off to school and thankful their parents started saving when they did.