There are two types of savings plans specifically designed to fund education expenses: Coverdell Education Savings Accounts and 529 Savings Plans.
A Coverdell account is designed for families in a lower income bracket who do not plan to contribute more than $2000 per year to the account and will make all contributions before the child turns 18. Offering investment flexibility that is superior to the 529 plan, potentially lower costs, and tax-free treatment not just for college expenses but for a wide range of elementary and secondary school costs (K-12) as well, the Coverdell is a worthy competitor for your education-savings dollars. If your child is young enough–not yet 18 years old–and your income is low enough (the income phase-out is $95,000 to $110,000 for a single taxpayer and $190,000 to $220,000 for a married couple filing jointly), you can contribute up to $2,000 per year to a Coverdell for that child.
Unlike 529s, Coverdell assets are not revocable. The account must be established for the sole benefit of the child and the assets belong to the child, In fact, the Coverdell has a custodian–and it’s not you. The custodian is the bank or other financial institution you use to open the account, much like the way you open an IRA.
As the “responsible individual”, you decide on investments and distributions, but distributions from the account are always paid to the beneficiary and cannot come back to you. Unspent funds remaining in the account when your child reaches age 30 must be distributed at that time, subject to tax and a 10% penalty on the account growth if he or she does not have qualified education expenses in that year. Federal tax law says the beneficiary can be changed to another family member below age 30 without triggering tax or penalty.
529 Savings Plans are more flexible than Coverdells but unlike the Coverdell, funds from the account cannot be used to pay for elementary and secondary school expenses and have more limited investment options. A 529 Savings Plan, officially known as a “qualified tuition program” are state-sponsored savings plans that provide a number of tax benefits. There are two main types of 529 plans: Section 529 prepaid programs and Section 529 savings programs. The latter is more common, as currently, only 10 states offer prepaid programs.
529 savings programs work similar to a Roth IRA by investing your after-tax contributions in mutual funds or similar investments. You get a choice of investment strategies, though you’re limited to the options offered by your state. When you need to withdraw money to pay for your child’s education, you just direct the program administrator to distribute the required funds to you or your beneficiary.
529 Savings Plans are highly flexible, allowing you to change the beneficiary at any time. This means that you can change the beneficiary to a sibling if your child decides not to go to college. The plans are professionally managed by experienced investment managers and offer generous contribution limits.
Though both Coverdell and 529 plans can be used to save for college, there are a number of key differences between the two. 529 plans have much more generous contribution limits and offer a greater degree of flexibility, except when it comes to investment options. Coverdells offer much greater control and flexibility when it comes to investments but are much more restrictive when it comes to contribution limits, income level restrictions, and age restrictions.
A key difference between Coverdell and 529 Savings Plans is that there are no age limits on 529 plans. When trying to decide between Coverdell vs. 529 plans, keep in mind that the 529 allows super funding, so you have the option for 4-year gift tax averaging. Furthermore, 529 plans, unlike Coverdells, have no annual contribution limits or income restrictions on contributors, other than the gift tax limitations.
Overall, a 529 plan is a good choice for most families. These plans have few limitations, offer tax benefits, and are designed to help families pay for college, as well as elementary and secondary school tuition.
Both 529 plans and Coverdells are excellent options for families to save for college. 529 plans are more flexible, have fewer limitations, and are generally a solid option for any family. If you meet the criteria and will not be bothered by the age or contribution limitations, a Coverdell can also be a great option that allows you more freedom to choose your investments. You can also roll your Coverdell over to a new 529 plan if you find that to be a better fit. To get started, contact us by clicking here.
