Two Ways to Save for College

Perhaps you’re familiar with 529 savings plans, which allow you to set aside funds for your child’s college education and simultaneously benefit from tax advantages and other incentives. But you might not have heard about another way to save for college: the Coverdell Education Savings Account (ESA). While the both are education saving plans, there are a few important differences that might affect your decision on which plan is right for your specific situation.

While contributions to either plan are not deductible on federal taxes, the money deposited in the accounts grows tax free. Distributions from the accounts remain tax-free provided the money is spent by or for the beneficiary on qualified educational expenses. These expenses generally include tuition, books, supplies, room and board, and other mandatory fees. While most people designate a child, grandchild or other relative as a beneficiary, you can also designate a non-relative.

One difference is that, contrary to the Coverdell ESA, 529 contributions may be eligible for state-tax reductions, depending on the state of your residence. Moreover, Coverdell ESA savings must be used before age 30 or income tax and a penalty will be charged on gains.

Another significant difference is limitations on how much money you can contribute to each type of plan. A Coverdell ESA allows total annual contributions for your beneficiary of no more than $2,000. If multiple family members contribute to accounts on behalf of your child, the total amount contributed for all accounts per child cannot exceed the $2,000 annual limitation. Amounts above the limit trigger a tax bill on the excess.

To qualify for the maximum $2,000 contribution, the individual must have a modified adjust gross income of $95,000 or less, and for a couple, $190,000 or less. The higher the contributor’s income, the lower the maximum allowed contribution, reaching zero for individuals earning $110,000 or more, and couples earning $220,000 or more.

Coverdell ESAs also have a contribution age limit of 18. This also means that if you were to start contributing to the plan each year at your child’s birth, the maximum amount you could have contributed when the child reaches 18 would be $36,000. Even with investment gains accrued over 18 years, this probably would not cover your child’s college education expenses.

The maximum contribution amount for 529 plans varies by state. Also, some states allow you to deduct contributions from your state tax return. According to the IRS, “Contributions cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary.” Also, there is no age limit for the 529.

Rather than imposing annual or age contribution limits, many 529 plans impose lifetime limits. These limits vary by state, but all exceed $200,000, which makes these plans attractive to parents anticipating higher college expenses for their child.

Coverdell ESAs and 529 plans also differ greatly in the investment options available and the ways you’re allowed to use funds. States usually limit investment options for 529 plans to annuities or mutual funds. Some plans offer more aggressive investments for younger beneficiaries and more conservative options as the child nears college age. A Coverdell ESA, however, offers more flexible investing options, which would let you invest in the assets of your choosing.

The flexibility of a Coverdell ESA also extends to how you’re allowed to use the funds. In addition to higher education expenses, you can also use the funds to pay for public, private or religious elementary and secondary school (kindergarten through grade 12) expenses. For example, you can use the funds to help pay for the tuition for your child’s private elementary school. Thus, a Coverdell ESA can give you tax advantage benefits for many of your child’s schooling costs, regardless of whether they attend college. This contrasts with a 529 plan, which can only apply to qualified expenses for college and other post-secondary training.

Thus, there are pros and cons to both saving plans. In fact, parents can consider contributing to both types of plans. When it comes to saving for college, it makes sense to start as soon as the child is born, especially in the case of a Coverdell ESA.