As part of our preparation for parenthood, my wife and I have been examining college savings programs. The two most common college saving plans are the 529 College Savings Plan and the Coverdell Educational Savings Accounts (ESAs).
529 College Savings Plan vs. Coverdell ESA
Similarities. These college savings plans both work similar to Roth IRAs – contributions are non-deductible and grow tax free. Withdrawals are also tax free for qualified higher education expenses. 529 Plans and Coverdell ESAs are viewed the same for financial aid purposes. They are considered the assets of the custodian (the person who opened the account), and withdrawals by the beneficiary are not considered taxable income when used for college expenses. Both plans can be transferred to another beneficiary without penalties or fees.
Differences. The major differences between the 529 Plans and Coverdell ESAs are listed below.
Types of accounts:
- 529 Plan: Two – Prepaid college tuition and savings plan
- ESA: Only one
Control of account:
- 529 Plan: Account holder controls when withdrawals will be made and for what purpose, and can change beneficiaries at will. There are no restrictions regarding when funds must be used.
- ESA: Account holder can change beneficiary at will. If money is not transferred to a new beneficiary or used for higher education costs, then the beneficiary receives the assets when they turn 30 and the account will be assessed taxes and penalties.
Age limit for contributions and withdrawals:
- 529 Plan: None.
- ESA: Must be under 18 to receive contributions, must use assets before age 30.
- 529 Plan: Between $100,000 and $350,000 depending on state
- ESA: $2,000 per year from all sources
Income limits for contributors:
- 529 Plan: No income limit.
- ESA: To qualify for the max $2,000 contribution, your AGI must be less than $95,000 for single filers and $190,000 for married couples. Contributions will drop to $500 per year in 2010 if Congress does not extend the current limits. More about ESA contribution limits.
State tax deductions or credits for contributions:
- 529 Plan: Yes, depending on state plan and residency.
- ESA: No.
Uses for plan assets:
- 529 Plan: Higher education only.
- ESA: Through 2010 assets can be used for K-12 and higher education.
- 529 Plan: Stocks, bonds, mutual funds, CDs. Can only change investment allocation 2 times per year.
- ESA: Stocks, bonds, mutual funds, CDs. No limit to changes in investment allocation.
529 College Savings Plan offers more flexibility than a Coverdell ESA
In my opinion, the 529 Plan is a more versatile plan, especially if you will have other people contributing money toward your child’s education – the $2,000 limit for ESA contributions is more difficult to track when there are multiple people contributing.
The Coverdell does have several advantages, including the ability to use the funds for K-12 (through 2010 unless extended), make unlimited changes to asset allocation, and ESAs may have better investment options, depending on the state in which you open your 529 College Savings Plan.
The good news is that you can have both plans for your children and you can roll a Coverdell ESA into a 529 College Savings Plan. These plans have a lot of small print and conditions, so I recommend reading the details for your state 529 plan or reading more about the Coverdell ESA before opening an accout and making contributions.