College savings plans: Coverdell versus 529 plan

Navigating College Savings: Understanding 529 Plans & Coverdell ESAs

Keystone Financial Group |
Categories
College Savings
College

Navigating college savings is a significant concern for many families. With rising tuition costs and the increasing necessity of higher education for career advancement, parents and guardians are keenly focused on finding effective ways to set aside funds for their children’s educational future. Two popular options for saving are 529 Plans and Coverdell Education Savings Accounts (ESAs). This article will delve into the features, benefits, and limitations of both, helping you make an informed decision based on your family’s needs.

1. Understanding 529 Plans

As you begin researching your options for navigating college savings, you’re likely to come across this popular option. Let’s dig into the details.

What is a 529 Plan?

A 529 Plan is a tax-advantaged savings plan designed to encourage saving for future education costs. Legally known as “qualified tuition plans,” 529 Plans are sponsored by states, state agencies, or educational institutions. They are authorized by Section 529 of the Internal Revenue Code.

Types of 529 Plans

There are two main types of 529 Plans:

  • Savings Plans work much like a retirement account, where investments can grow tax-deferred and distributions to pay for the beneficiary’s college costs are federally tax-free.
  • Prepaid Tuition Plans let savers purchase units or credits at participating colleges and universities for future tuition and mandatory fees at current prices for the beneficiary.

Advantages of 529 Plans

  • Tax Benefits: Contributions grow tax-deferred, and withdrawals for qualified education expenses are exempt from federal tax. Some states also offer tax benefits such as deductions or credits for contributions.
  • High Contribution Limits: Most plans allow contributions until all account balances for the same beneficiary reach $235,000 to $500,000.
  • Flexible: Account owners can choose from a variety of investment options and can change the beneficiary if the original beneficiary does not need the funds for college. Recent changes in the Secure Act 2.0 also allow for 529 funds to be rolled over into a Roth IRA for the beneficiary if not used for college. However, some caveats apply (see below).

Limitations:

  • Investment Options Limited: Investment options in 529 Plans are often limited to those selected by the plan. There are no guarantees.
  • Penalty for Non-Qualified Withdrawals: Non-qualified withdrawals are subject to income tax and a 10% federal penalty on earnings.
  • Restrictions on Use of Unused Funds: While unused 529 Plan funds may be rolled into a Roth IRA tax-free, there are some caveats to be aware of. The plan must have been opened at least 15 years before rolling over, it can only be rolled over into the beneficiary's name, and there are annual and lifetime caps on how much can be rolled over, as well as a few other considerations. See more info here. 

2. Exploring Coverdell Education Savings Accounts (ESAs)

Now, let’s discuss another common option you might consider as you’re navigating college savings.

What is a Coverdell ESA?

A Coverdell ESA is a tax-advantaged savings account designed to pay for the beneficiary’s educational expenses, from elementary to post-secondary school.

Benefits of Coverdell ESAs

  • Tax Advantages: Similar to 529 Plans, the earnings in a Coverdell ESA grow tax-free, and withdrawals for qualified education expenses are also tax-free.
  • Wide Range of Investment Choices: Unlike 529 Plans, Coverdell ESAs can be used for a range of investments, similar to those available in IRAs.
  • Use for K-12 Expenses: Funds can be used not only for college expenses but also for elementary and secondary education, including tuition, books, and uniforms.

Limitations

  • Contribution Limits: Contributions are limited to $2,000 per beneficiary per year, regardless of the number of accounts set up in the beneficiary’s name.
  • Income Restrictions: Eligibility to contribute to a Coverdell ESA phases out at modified adjusted gross incomes between $95,000 and $110,000 for single filers and between $190,000 and $220,000 for joint filers.
  • Age Restrictions: Funds must be used by the time the beneficiary turns 30, with some exceptions for special needs beneficiaries.

3. Choosing Between 529 Plans Versus Coverdell ESAs

When deciding between a 529 Plan and a Coverdell ESA, consider the following factors:

  • Contribution Amounts: If you plan to save a significant amount, a 529 Plan may be more suitable due to its higher contribution limits.
  • Investment Flexibility: If you prefer more control over your investments, a Coverdell ESA offers more flexibility.
  • Use of Funds: If you need savings for K-12 expenses, a Coverdell ESA is advantageous.
  • State Tax Benefits: Many states offer tax benefits for contributing to a 529 Plan, which might not be available with a Coverdell ESA.

Navigating College Savings: Determining the Right Approach for Your Family’s Needs

Navigating college savings options and choosing the right one for you involves weighing the benefits and limitations of each type of account. By understanding the differences between 529 Plans and Coverdell ESAs - as well as other college savings strategies that may be available, you can tailor your college savings strategy to fit your financial situation and educational goals for your beneficiary. Careful consideration of the features of each option will guide you in preparing for the educational expenses ahead.

Want to discuss your options for saving for college? Reach out to our office to schedule a free college funding strategy session with a qualified college planning professional.

 

Sources:

[1] https://www.investopedia.com/terms/1/529plan.asp

[2] https://www.investopedia.com/terms/c/coverdellesa.asp

[3] https://www.schwab.com/learn/story/529-to-roth-ira-rollovers-what-to-know

Disclaimer:

The information presented here is for educational purposes only and is not a solicitation for the purchase of any financial product. The statements and opinions expressed are those of the author and are subject to change at any time. All information is believed to be from reliable sources; however, presenting financial professional makes no representation as to its completeness or accuracy. This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, accounting, legal, tax or investment advice.