Two Ways to Beat The High Cost of College

One recurring question from readers is about building a nest egg for the next generation. Parents often express interest in setting up an education savings plan for their children to pay for college tuition.

Two tax-advantaged education savings plans with proven advantages are the 529 plan and the Coverdell Education Savings Account (ESA).

The 529 Plan

There are two types of 529 plans—prepaid tuition plans and college savings plans. Every state has at least one type. The plans are sponsored by states, state agencies or educational institutions, which choose a plan manager and determine the rules and limits for the plan.

A college savings plan allows a saver to open an investment account to save for a beneficiary’s future qualified education expenses, which include college tuition, room and board, books, computers, and mandatory fees. Tuition for grades kindergarten through 12 also qualifies, up to $10,000 per beneficiary per year.

While the savings accounts are usually opened by parents, relatives, or friends, you can even open one for yourself if you plan to go to college. Plus, you can change the beneficiary to someone within the same family.

Tax-Advantaged, with Caveats

Contributions are not tax deductible on the federal level, but if withdrawals are used for qualified expenses, they are entirely federal tax free (and in many cases, also state tax-free). This means that growth (earnings) from your original contribution is not taxed.

Most states also offer a full or partial tax deduction or credit for 529 plan contributions. Additionally, some states allow you to choose a plan from another state. (Check your own state’s rules.)

You can withdraw money at anytime from the 529 plan, but beware most non-qualified withdrawals will be taxed and/or penalized.

The principal, your original contribution on which you’ve already paid federal tax, can be withdrawn tax-free, but any earnings will be subject to income tax and a 10% penalty if used for a non-qualified expense.

If you claimed state tax deductions for your contributions, you may lose those deductions and owe back taxes. Be sure to check if what you intend to use the withdrawal on is a qualified expense as far as the IRS is concerned.

In the case of a prepaid tuition plan, you prepay the tuition at a participating university—usually in-state and public—at current tuition prices for the beneficiary. The idea is that tuition will rise in the future so you want to pay the lower prices now.

However, the plan isn’t guaranteed by the federal government and only some states guarantee the principal, so it’s possible to lose money. And if the beneficiary decides to go to a non-participating university, the plan may only pay back a portion of your original investment.

While the contribution limits vary by state, beware that 529 contributions are considered a gift so it’s subject to the gift tax. If you want to avoid triggering the gift tax, you are limited to no more than $15,000 a year in contribution per beneficiary.

If you exceed that amount, you may be subject to a gift tax, depending on how much in gift you have given during your lifetime. Another drawback is that the savings account could negatively affect the beneficiary’s access to need-based student financial aid because the 529 counts as a family contribution to the student. There are also fees associated with these plans, so shop around and compare.

The Coverdell ESA

The Coverdell ESA is similar to the 529, but there are important differences.

One major difference is that for a Coverdell ESA, you can only contribute up to $2,000 per year for each beneficiary.

Secondly, there’s also an income limit. If you make more than $95,000 (single) or $190,000 (married and filing jointly) a year, you cannot contribute the maximum.

The amount you can contribute phases out until you reach $110,000 (single) and $220,000 (married), at which point you can’t contribute at all. There’s no income restriction for a 529 plan.

Thirdly, to qualify as a beneficiary, the beneficiary must be younger than 18 when the Coverdell ESA is opened and younger than 30 when the money is spent. In the 529, there’s no age restriction.

You may wonder why anyone would open a Coverdell ESA. In the past, Coverdell ESA used to have the advantage of permitting withdrawals to be used on pre-college expenses. However, recently the 529 plan has expanded to include qualified pre-college spending, too, so that advantage is gone.

The key advantage of a Coverdell over a 529 is that in a Coverdell you have the ability to self direct investments. If you know what you are doing in the stock market and you don’t want to buy pre-set portfolios, an ESA gives you the ability to manage the account. Provided your income qualifies, you could also open both a 529 and a Coverdell ESA.

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