529 vs. Coverdell

Show Notes

It’s great to have options, but it can lead to confusion when you’re trying to decide how best to save for your kids’ college education. A 529 savings plan is a great option, but it’s not your only option. Today we’ll compare 529 education savings plans to Coverdell accounts.

• We almost always advise parents to open a 529 plan to pay for their kids’ college expenses, and no doubt it’s a great, tax-advantaged way to save, but a Coverdell account has at least one advantage that makes it worth considering.
• 529 & COVERDELL SIMILARITIES
• But first, let’s look at how the two plans are similar. To start, like 529 plans, Coverdell education savings accounts (or ESAs) give families a tax-advantaged way to save not only for college, but also for elementary and secondary expenses.
• That was always true for the ESA but not the 529. Five years ago, the 529 was changed so parents could use it for K-12 education up to $10,000 a year for qualified expenses.
• What do we mean by “tax-advantaged?” It doesn’t mean that your contributions to either an ESA or 529 are deductible on your federal tax return (although some states will give you a break there). It does mean that your earnings are allowed to grow tax-free in both types of accounts.
• So for either plan, you pay taxes on the money going in, but no taxes when you make withdrawals for qualified educational expenses. Those expenses are generally defined as tuition and fees, books and some room and board expenses.
• Also, when you apply for college aid using the Free Application for Federal Student Aid (FAFSA), both ESAs and 529s will be counted as family assets.
• You’re probably thinking, “Well, if they’re so much alike, why do we need both?” Well, there are major differences between the two.
• DIFERENCES BETWEEN 529 & COVERDELL
• First, ESAs were really designed for low and middle income families, so they come with income restrictions. Your modified adjusted gross income can’t exceed $190,000 for married couples filing jointly or $110,000 for single filers.
• 529 plans don’t have income restrictions, although individual state 529 plans may set their own maximum balance, and those range around $235,000 to over a half million dollars.
• So that distinction could be important for some folks. ESAs have an income limit whereas 529s do not. But that’s not the only difference. Here’s where the major advantage of the Coverdell ESA comes in …
• THE MAJOR ADVANTAGE OF A COVERDELL ESA
• The big advantage here is in your investment options. A 529 plan is similar to a 401k when it comes to investing. You can only invest in the options provided by the plan, and they tend to be traditional assets like mutual funds.
• An ESA, on the other hand, is more like an IRA. In fact, they were actually called Education IRAs until the name was changed 20 years ago.
• You can open an ESA at a bank, credit union or brokerage. And from there, you can invest in almost anything, including individual stocks and bonds, real estate investment trusts, mutual funds and exchange-traded funds. So flexibility is the key advantage that the Coverdell ESA has over a 529.
• And now you may be thinking, “If ESAs are so great, why do you usually recommend 529 plans? It’s because ESAs also have two disadvantages.
• ESA DISADVANTAGES
• First, contributions are lower with ESAs. You can only put $2000 a year into an ESA.
• With a 529 plan, individuals can contribute up to $16,000 a year without having to fill out the federal gift tax form 709. Contributions above that amount count against an individual’s lifetime gift exclusion of $12.06 million .. so it’s certainly not a problem for most folks.
• The ESA has one other disadvantage: an age restriction that the 529 does not have. You have to make all of your contributions to an ESA before your child turns 18, and then use those contributions and earnings before the child reaches age 30.
• That could be a problem for students who might consider grad school, especially med school which requires an additional four years of study. In that case, the 529 is definitely better than the ESA.
• Now, one final word. Whether you choose an ESA or 529 plan, it’s important to start saving early to make the most of compound earnings over the years. The goal is to borrow as little as possible for education. It’s easy to borrow but a lot harder to pay back student loans.

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