According to the College Board, the average cost of tuition and fees for the 2015–2016 school years was $32,405 at private colleges, $9,410 for state residents at public colleges, and $23,893 for out-of-state residents attending public universities.
Two of the most popular ways to save for college are the 529 plans and Coverdell education savings accounts.
529 plans let you save money for the college expenses of a named beneficiary, such as a child or grandchild. There are two types of 529 plans-college savings plans and pre-paid tuition plans. A college savings plan lets you save money in an individual investment account. A prepaid tuition plan allows you to prepay the cost of college at today’s prices for use in the future. However, with a prepaid tuition plan, you do not get to choose a portfolio and you have little say so in how your money is invested. The prepaid tuition plan is generally invested in a trust fund managed by professional money managers.
For Coverdell ESA you can customize your portfolio and choose your own investments.
Contribution Limits
At the federal level, there is no deduction for contributions made to a 529 plan or a Coverdell ESA (some states offer a state income tax deduction for using a 529 plan). Many 529 plans have a lifetime contribution in excess of $300,000 per beneficiary. Whereas the annual contribution limit for a Coverdell ESA is $2000 per beneficiary until age 18. You cannot make any contributions to a Coverdell ESA after the beneficiary reaches age 18. The exception is if the beneficiary is a child who has special needs. One other note, the Coverdell ESA does not work as well for grandparents and other relatives. If you contribute the max $2000 in one year and a relative opens an ESA for the same beneficiary and contributes $1000, the annual contribution has been breached. The beneficiary will owe a 6 percent tax on the $1000 excess.
Another drawback of the ESA is the ability to contribute if you earn over a certain amount for the year. As a single tax filer, your annual modified adjusted gross income (MAGI) must be less than $95,000 to make a full contribution; yet you can make a partial contribution if your income is $95,000 to $110,000. For joint filers your annual MAGI must be less than $190,000 to make a full contribution; yet if your income is $190,000 to $220,000, you may make a partial contribution. With a 529 plan, no income limits apply.
Federal Gift Tax
It is important to note that your contribution is considered a completed gift to the account beneficiary, so it qualifies for the annual federal gift tax exclusion. Because the annual maximum contribution allowed for an ESA is $2000, you won’t trigger the gift tax rules if this is your only gift to the beneficiary for the year. The 529 plans offer a special gifting feature. You can make a lump-sum contribution of up to $70,000 and elect to spread the gift evenly over five years, avoiding the federal gift tax, provided no other gifts are made to the same beneficiary during the five-year period. A married couple can gift up to $140,000.
Qualified Expenses
Qualified expenses for the beneficiary to use under the 529 plans are tuition, fees, books, computers and related equipment, supplies, special needs; room and board for minimum half time students.
The Coverdell ESA designates the same qualified expenses as the 529 plans in addition to certain elementary and secondary school expenses.
Federal Financial Aid and Scholarships
Federal financial aid treatment for both the Coverdell ESA and 529 college savings plans are identical. Each is counted as asset of the parent if the owner is the parent or the dependent student. Also, withdrawals that are used to pay for the beneficiary’s qualified education expenses are not classified as either parent or student income.
If the beneficiary receives scholarships, make sure you keep up with the value of these. As the owner of the Coverdell ESA and/or 529 plans, you will be allowed to withdraw that amount and refund yourself without penalty or taxes on the amount withdrawn.
Non Qualifying Withdrawals and Penalties
If you make withdrawals from a Coverdell ESA or a 529 plan that are not used for the beneficiaries qualified education expenses you will pay income tax on the earnings portion of the withdrawal. For 529 plans, the person who receives the nonqualified withdrawal pays the tax, (typically the account owner) while for Coverdell ESA’s the beneficiary generally pays the tax. Secondly, you will pay a 10 percent federal penalty on the earnings portion. Depending on the state you live in, you may also owe an additional state penalty on the earnings portion.
When the beneficiary of a Coverdell ESA turns 30 years of age, the funds in the ESA must be distributed within 30 days. The earnings may be subject to tax and 10% penalty on the account earnings if the beneficiary does not have qualified education expenses in that year. The funds in a 529 account can generally stay there as long as you like, though prepaid tuition plans may have restrictions on how long an account can remain open.
Changing Beneficiaries and Plans
Both the Coverdell ESA and 529 plans allow you to change beneficiaries to another member of the beneficiaries family member below age 30 without triggering tax or penalties.
You can open both a Coverdell ESA and a 529 account for the same beneficiary and contribute to both types of plans in the same year. If you open a Coverdell ESA and decide later that you would prefer to be in a 529 plan, you are permitted to transfer funds to the 529 plan as long as you keep the beneficiary the same. You cannot go from a 529 plan to a Coverdell ESA.
In my opinion both plans are a fine way to save for college.
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As a cautionary note on 529 Plans it should be vetted with more scrutiny for non-Americans. On relinquishing my Green Card I was subjected to an exit tax which included the life to date gains in the 529 plans established for my children. The positive basis was taxed as other income (read: highest marginal rate) in my year of exit. Going forward the plans work as advertised, but in retrospect a taxable account would have been better net/net.
Thank you jcging13 for the added info. Much appreciated.
As a father of three young children, I need to start sticking money somewhere for college. Need to definitely look into these more. Or hit the winning powerball…lmao…..better just start investing. ….thanks for the read…..