Education Savings Plans Still Suffer From Lack of Awareness

Named for a section of the Internal Revenue Service code, 529 plans are tax-advantaged accounts that can be used to save for education expenses. Offered by every state and many brokers, any growth generated by money invested through such accounts grows tax-free as long as it is used for qualified education expenses. Some states also offer their residents state income tax deductions or credits for the money contributed to their 529 plan accounts.

Originally, the accounts were designed to help parents save for college. However, today many states allow parents to use 529 plan account money to help pay for public, private, and religious K-12 school expenses as well.

Some parents may have been hesitant to use 529 plans because of concerns that the money will not end up being necessary, perhaps because their child earns a scholarship or chooses not to go to college. However, money not needed for one child may be transferred to another child or even to parents who decide to go back to school.

More recently, changes in tax law have made the plans even more flexible. Parents can now roll over up to $35,000 (a max of $6,500 per year) of unused money into a Roth IRA for the benefit of the child.

Whereas most 529 plans restrict their investment options to age-based portfolios and perhaps a few individual mutual funds, Coverdell accounts may be invested in a much wider variety of mutual funds, exchange-traded funds, and more.

The major downside to using a Coverdell account is that only $2,000 per beneficiary may be contributed yearly for joint tax return filers and that amount is reduced for higher-income households. Joint return-filing households with modified adjusted gross income of more than $220,000 cannot contribute to such accounts. By contrast, there are no income-based restrictions for contributing to a 529 plan account and annual contribution limits are much higher.

If your income doesn’t prevent you from qualifying for a Coverdell, it can be a good supplement to a 529 plan, especially since you could likely follow your SMI strategy of choice with a Coverdell. In addition to the broader array of investment options, with a Coverdell, there are no restrictions on how often you can make portfolio changes. With 529 plans, you are restricted to two changes per year.