There are two primary college savings plans established by the government that can help you prepare your finances for your children’s education. 529 College Savings Plans, and the Coverdell ESA can enable you to provide that education, but each comes about in a somewhat different way.
The 529 College Plan
529 plans are sponsored by the individual states, and rules can vary depending on your state of residency. Contributions to a 529 plan are not deductible for income tax purposes, however the earnings on your contributions can grow tax-deferred. The funds can be withdrawn free from federal income tax, as long as they are used for qualified education expenses.
Contribution amounts are set by the individual states. Unlike Coverdell ESAs contribution amounts will vary from state to state, though there is no income limit restricting your contributions.
Contribution limits. A married couple can contribute up to $26,000 per year ($28,000 in 2013), while single taxpayers can contribute up to $13,000 ($14,000 in 2013). It’s easy to see how contributions this generous can enable you to fund your child’s entire college education as long as you start early enough in their lives.
Lump sum contributions. 529 plans allow you to make lump sum contributions covering a five year period. A married couple can contribute up to $130,000 ($140,000 in 2013), and a single person can contribute up to $65,000 ($70,000 in 2013). The purpose of the five-year period is to enable you to escape having to pay gift tax for your lump sum contribution.
No age limits. 529 plans have no age limit for the plan beneficiary.
529 uses. Funds may be used only to pay qualified expenses at accredited colleges and universities, both public and private.
Investment options are limited. All assets held in a 529 plan must be invested in portfolios managed by state approved investment companies. You can change your portfolio selection once every 12 months, but you do not have the option to invest in either accounts or securities of your choice.
The Coverdell ESA
The ESA allows contributions of up to $2,000 per year and must be made by the filing date for the tax year (generally April 15). Much like traditional and Roth IRAs, there is also a phase out of contributions based on adjusted gross income. You can take the entire contribution with an income of up to $190,000 after which it begins to phase out. At an annual income of $220,000, contributions are no longer permitted. Unlike IRAs, contributions are not tax-deductible, though earnings on those contributions can grow tax-deferred basis.
Broader applications. The potential uses of the funds held in a Coverdell ESA are broader than they are for a 529 program. ESA funds can be used to pay for qualified education expenses from kindergarten through high school, as well as college. They can be spent on purposes related to school including the purchase of computers.
ESA’s are self-directed. Unlike 529 plans the ESA plans are completely self-directed when it comes to investing the funds. You can hold the funds in a brokerage account and invest in stocks, bonds, mutual funds or ETF’s.
Age limits. Under an ESA all plan assets must be distributed and used by the plan beneficiary before turning age 30. Any funds in the plan once the beneficiary turns 30 will automatically be considered distributions, subject to both income taxes and penalties. In addition, funding of a Coverdell ESA is only permitted up until the child’s 18th birthday, although contributions can continue if the child is defined as a special needs beneficiary.
Which Plan Is Better?
In general, 529 plans are far more flexible and generous than Coverdell ESA’s. Not only do they allow for much larger contributions, but there are no qualifying income limits either. They can also benefit a student at any age, while the Coverdell ESA must be used by age 30. 529 plans however are more targeted in that you are restricted to using the funds only in connection with attendance at a college or university. With the 529 plan, it will be possible to fund a child’s entire education.
The Coverdell ESA will be more advantageous if you need a smaller amount of money to cover education expenses that are not related exclusively to college. You can use them much earlier in life, with much greater flexibility. Coverdell ESA’s also have the advantage of being totally self-directed. You can choose the trustee and investments that you hold in the plan.
Which plan you use will depend on what you need the plan to do.