There are a number of tax-advantaged college savings vehicles available to help families save for the ever-increasing costs of higher education.  Two of the most popular methods for saving for college are the 529 College Savings Plan and the Coverdell Educational Savings Account (ESA).  Is one of these methods better than the other? How do you choose between the ESA or the 529 savings plan? Let’s take a look.

Choosing Between a Coverdell ESA and 529 Plan

Age Limitations

Perhaps your choice of college savings plan will be determined by age limitations. Contributions can be made to a beneficiary of any age with 529 savings plans, while the Coverdell ESA requires that beneficiaries be under the age of 30.  When it comes time to withdraw money from a 529, beneficiaries can be any age and can use the funds over the course of a lifetime provided they are for approved education expenses.  Funds from a Coverdell ESA must be withdrawn and used by the time the beneficiary reaches the age of 30.

Annual College Savings Plan Contribution Limitations

Coverdell contribution limits max out at $2,000 per year, per beneficiary.  If multiple people are contributing to the same beneficiary’s Coverdell ESA, a maximum of $2,000 can be received, making coordination and communication essential to avoid taxes or penalties.

There are no annual contribution limitations for 529 College Savings Plans.  The amount allowed per plan over the lifetime of the plan varies depending on the state in which the 529 is opened, but ranges from $100,000 to $365,000.

Income Limitations for  College Savings Plan Contributions

Under the 529 plan, it doesn’t matter how much you earn.  Everyone can contribute to a 529 plan.  For the full $2,000 contribution to a Coverdell ESA, you need adjusted gross income (AGI) of less than $95,000 per year for a single tax filer or $190,000 per year for joint filers.  Higher income earners can contribute a smaller amount per year; but if the maximum income limits are reached, the individual may not contribute to a Coverdell ESA at all.

Tax Advantages and Benefits of College Savings Plans

Neither the Coverdell or 529 Plan allow federal income tax deductions on contributions, but the 529 plan may allow tax deductions on state income taxes, depending on your state laws. Earnings in both plans grow tax-free.  Withdrawals from a Coverdell ESA or 529 plan for qualified expenses can be taken federal tax free, as well. Here are some more tax advantages of 529 Plans.

What Are Qualified Withdrawals?

The Coverdell ESA and 529 Plans each have their own list of qualified withdrawals.  For Coverdell ESAs, you can use money for any educational expense from kindergarten to grad school.  Tuition, fees, books, computers, internet access for education, transportation to get to school, private or public school fees, etc.

Money from a 529 plan must be used for higher education expenses at accredited colleges and universities, for educational expenses like tuition, fees, books, and room and board.

How The College Savings Plans Impact Financial Aid

Money in a Coverdell ESA or a 529 plan is considered an asset of the custodian (usually the parent) and not the beneficiary.  If a parent holds the Coverdell ESA, it will be included in the parent’s assets.  Parental assets are assessed at a lower rate than student assets when calculating financial aid awards, which helps minimize the impact of money in an ESA.

Investment Options

Both the Coverdell ESA and 529 account allow for stocks, bonds, CDs and mutual fund investment options.  With the Coverdell, you can change your investment allocations as frequently as you want.  With the 529 plan, you can only change your investment allocations twice per year. Here is more information about how to open a 529 College Savings Plan, and where to open a Coverdell ESA Plan.

Which is Better – Coverdell ESA or 529 Plan??

Overall, the 529 plan is more flexible regarding who can contribute, contribution limits, ages that beneficiaries can use the funds, and it offers the state income tax deduction in some states. The advantages of a Coverdell include more flexibility for investments (ability to open an account virtually anywhere and change investments at will) and it offers slightly more liberal qualified withdrawal opportunities.

Can’t Decide?

If you’re still not sure which college savings option is the best for you, you can actually contribute to both a Coverdell ESA and a 529 plan. These plans are independent of each other.

College tuition is expensive – and it’s not getting any cheaper. Thankfully there are a few programs out there which make it easier to save for college. This is especially important if you if you are saving for your child’s tuition and will not be able to use your GI Bill benefits to help pay for your child’s college. Yesterday, we looked at the 529 College Savings Plan, which is a great way to save for college tuition. Today we are going to look at another college savings plan that offers tax benefits.

Coverdell Educational Savings Account (ESA)

Once called an Education IRA, a Coverdell Educational Savings Account (ESA) is named after Senator Paul Coverdell, who introduced this college savings plan.  Coverdell ESAs are similar to IRAs, but they are designed to save money for education rather than retirement.  Because of this, the name was changed for Education IRA to Coverdell ESA, to more accurately reflect what the money is being saved for.

How the Coverdell ESA Works

A Coverdell ESA is a savings or investment account for college tuition. You can open an account through a mutual fund company, bank, or brokerage firm, choose the investments, and then send in contributions.  The person who opens the account is considered the “responsible person” and controls the money and investments until the beneficiary reaches the age of majority for the state in which they live in.  For most states, this is the age of 18.

Contribution limits. Annual contribution limitations for Coverdell ESAs are $2,000 per student, however, contribution limits may be limited based on the modified adjusted gross income (MAGI) of the person making the contributions. Here is additional information about contributions:

• Anyone can contribute up to $2,000 in a Coverdell ESA for the benefit of someone under the age of 18, unless you exceed income limitations.  For single tax filers, if you make more than $110,000 annually you will not be able to contribute personally into a Coverdell ESA.  For joint tax filers, you must make less than $220,000 per year to contribute.
• There is also a phaseout income range which allows for lower contribution amounts. This is based on a MAGI for single filers: $95,000 and $110,000; or income between $190,000 and $220,000 for joint filers.
• If you exceed the income limitations for contributing to a Coverdell ESA, you can give the money as a gift to the student beneficiary, who can then contribute or open the ESA themselves.

Tax Benefits of Coverdell ESAs

Coverdell ESA contributions are not tax deductible, but earnings and withdrawals from a Coverdell ESA are tax free as long as distributions from the Coverdell are made for qualified educational expenses.  Qualified expenses include college costs, but can also extend to private schools at the elementary or secondary school levels, uniforms, computers, and transportation for education purposes.

If a beneficiary of a Coverdell ESA uses the money for anything other than qualified education expenses, they are subject to both a 10% penalty and the money is treated as ordinary income at tax time. Money in Coverdell ESAs must be used by the time the beneficiary is 30 years old, whether it is used for qualified educational expenses, used for non-qualified expenses and assessed a 10% penalty, or transferred to a relative.

How to Choose a Coverdell ESA

Just like any other investment, the Coverdell ESA can be opened through brokerage firms, banks, or mutual fund companies.  You’ll want to compare fee structures and commissions when making your selection, as well as the types of investments to include. Here is additional information on where to open a Coverdell ESA Plan.

One of the best ways to save for college is with a 529 College Savings Plan, which is named after section 529 of the Internal Revenue Code, 26 U.S.C. 529.  Why should you care about a 529 plan? Because they can offer some very nice tax benefits as an incentive to save for college. Let’s take a look at 529 plans and why they are a great way to save for college.

529 College Savings Plan

Where can you open a 529 plan?

Each state has it’s own version of the 529 plan and you can choose to invest in a 529 plan from your state or from another state. However, it’s often more advantageous to invest in a 529 plan within your state of residence because many states offer tax advantages and potential scholarship opportunities.  Additionally, 529 plans from your state of residence are exempt from financial aid calculations, meaning the money saved in the plan won’t prevent your eligibility for other sources of financial aid programs.

Two Types of 529 Plans – Prepaid and Savings

There are two types of 529 plans, one is a prepaid plan and the other is a savings plan.

Prepaid 529 Plan. Prepaid 529 plans allow you to buy tuition credits at today’s costs, which can be used in the future.  The advantage of this is the ability to lock in your college costs before inflation and time causes them to increase.  Prepaid 529 plans are administered by individual states for state run universities, or by individual colleges.

529 Savings Plan. The savings version of the 529 plan functions similar to a retirement account, but it is used for college tuition and eligible expenses. The savings plan can have different types of investments, such as Certificates of Deposit, mutual fund index funds, and ETFs.  These plans offer more flexibility, but are subject to market returns, so you could potentially make or lose money.  Savings 529 Plans are administered through states at times, but the actual record keeping and administrative work involved in the plans are typically handled by financial services companies or mutual fund companies.

What 529 Plans Can Be Used For

Qualified expenses for 529 plan funds include tuition, room and board, books, supplies, equipment and college related fees required to study at any vocational school, accredited college or university program in the United States.  Some foreign universities also qualify. 529 savings can be used in conjunction with the GI Bill to help pay for expenses not covered by your GI Bill benefits.

You may not use money from a 529 plan to pay back student loans or student loan interest.

Tax Advantages and Benefits of 529 Plans

Many people prefer the 529 plans for college savings vehicles because of their tax advantages.

• Tax deferred growth. Money in a 529 account grows tax-deferred and can be withdrawn tax-free if used for qualified educational expenses for the beneficiary of the 529 plan.  The donor (person who opens the 529 plan) remains in complete control of the fund.  Most 529 plans will even allow the donor to reclaim the money for themselves if things change, although the earnings portion of non-qualified withdrawals are subject to income tax and a 10% penalty.  The assets returned to the donor are also not included in the donor’s gross estate for estate tax purposes.
• Tax deductions on contributions. On a federal level, contributions to a 529 are not deductible from income tax liabilities, but most states allow state income tax deductions for all or part of 529 contributions.
• Withdrawals may not be considered taxable income. When you take distributions from your 529 plan for qualified higher education expenses, the money is exempt from federal income tax.
• Watch out for non-qualified distributions. If you take money from your 529 plan for anything other than qualified educational expenses, the distribution is subject to income taxes and an early distribution penalty of 10% on the money the plan has earned except under a few circumstances.

529 plan eligibility

Everyone is eligible for a 529 plan – there are no income or age restrictions.  The opening contribution generally has a low minimum requirement, and the ongoing contribution requirements are low, as well.

Ability to transfer 529 funds to family members. Another benefit of 529 plans not commonly found in college investment vehicles is the ability to transfer the money from one beneficiary to another family member without penalty.  Qualified family members may include son, daughter, step children, adopted children, foster children, siblings and step siblings, parents, step parents, nieces and nephews, aunts, uncles, in-laws, first cousins, or the spouse of any qualified family member.

Interested in learning more about 529 college savings plans? Check out these articles:

• How and Where to Open a 529 College Savings Plan.
• 529 College Savings Plan vs. Coverdell ESA.

FYI – a Coverdell ESA is another type of college savings plan that offers tax advantages. Here is more information about a Coverdell Educational Savings Account (ESA), and How and Where to Open a Coverdell ESA Plan.