It’s easy to get caught in the complex web of savings plans and strategies when you’re planning on financing your children’s college educations. What’s more, each family has their own set of financial priorities, unique circumstances and trade-offs to consider. To help simplify the process, we’ve compared the two most well-known, tax-advantaged education savings vehicles: the 529 plan and the Coverdell Educations Savings Account.
While both offer tax-free earnings when withdrawals are used toward education-related expenses, each plan differs in a few ways that may sway your decision when it comes to choosing which is best for you and your family.
529 Plans Features
One of the most common savings vehicles is the state-sponsored college savings plan: the 529. This type of plan’s primary advantages are associated with the contribution limits. There is no limit on annual contributions; however, there are lifetime limits which are usually between $200,000 and $400,000 (varies state to state). If you choose to take advantage of the frontloading feature of the 529, you can contribute up to five years of the annual gift exemption into your children’s 529s without any gift tax issues. Though, be wary when “superfunding” this plan; in some rare cases, meticulous savers have more than they need.
A 529 plan’s investment gains grow and can be withdrawn tax-free, and the withdrawals are federal and state income tax-free for most states (as long as both are used for qualifying expenses). For states that don’t offer tax-free benefits, 34 states (including Washington, D.C.) offer partial or full tax deductions on 529 contributions. Aside from the restrictions on how the funds are allocated, the 529 plan itself is pretty flexible and you can change the beneficiary twice a year.
Coverdell Educational Savings
A Coverdell Education Savings Account (ESA) is a trust or custodial account whose sole purpose is to pay for qualified education expenses for beneficiaries under the age of 18 (or special-needs beneficiaries). Once the beneficiary hits 18, you cannot continue contributing to the account. While there is no limit on the number of accounts your child may have, there are limits to total contributions. A Coverdell ESA maximum contribution limit is $2,000/year, but Coverdell ESA’s may be used for private K-12 education expenses or qualifying college expenses (tuition and fees, books, supplies, equipment, room and board). Most traditional mutual funds, exchange traded funds, stocks, bonds or CDs may be used inside of a Coverdell ESA.
Coverdell ESAs enjoy tax benefits similar to a Roth IRA. Money grows tax-deferred and may be removed tax-free for qualifying expenses, although contributions themselves aren’t deductible. According to the IRS, if an account’s distributions aren’t more than your child’s qualified education expenses at an eligible educational institution (in one year), then your child won’t owe tax on the distributions.
With lower fees and more investment options, the Coverdell ESA might be more attractive for families looking to invest in a plan who want to save for K-12 education expenses. However, with the income limits and a use-it-or-lose-it rule on an ESA, the 529 plan might fit better for those who want to make larger contributions with more tax-advantages and guarantee the funds be used for college-related expenses. As always, save for your retirement first and then strategize your children’s savings thereafter. Speak with an advisor on which plan fits best with your unique financial situation.
Personal Capital Education Planning Guide Series
- How to Pay for Kids’ College
- When to Start Saving for College
- When Does a 529 Make Sense?
- 5 Tips on Saving for College and Retirement
- Three Options When You Have Extra 529 Funds
- Case Study: Funding College While Saving for Retirement
Paul Deer, CFP®
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