 |
| Home | Get Inspired | FAQs | Glossary | Myths vs Reality |
Section 529 plans and Coverdell education savings accounts are two of the most popular ways to save for college. But which savings option is right for you?
A Coverdell ESA is a tax-advantaged savings vehicle that lets you save money for the qualified education expenses of a named beneficiary, such as a child or grandchild. Qualified education expenses include college expenses and certain elementary and secondary school expenses. 529 plans are tax-advantaged savings vehicles that let you save money for the college expenses of a named beneficiary, such as a child or grandchild. There are two types of 529 plans--state savings plans and prepaid tuition plans. A state savings plan lets you save money in an individual investment account. A prepaid tuition plan pools your contributions with those of other investors and allows you to prepay the cost of college at today's prices for use in the future. Contribution limits and restrictions The annual contribution limit for Coverdell ESAs is $2,000 per beneficiary. That's considerably less than you can contribute to most 529 plans (most plans have lifetime contribution limits of at least $250,000 total). So the more money you have to invest, the more attractive a 529 plan becomes. Just make sure you're familiar with all the contribution rules before you invest in a 529 plan. In addition to the lifetime contribution limit, some plans impose annual maximums and/or minimums. Another potential drawback of the Coverdell ESA is that you may not be able to contribute if you earn over a certain amount for the year. The allowable contribution is gradually phased out based on your modified adjusted gross income (MAGI) for the year. For single tax filers, your annual MAGI must be less than $95,000 for you to make a full contribution (a partial contribution is allowed if your income is $95,000 to $110,000). For joint filers (if you're married, you must file a joint return to be eligible to contribute to a Coverdell ESA), your annual MAGI must be less than $190,000 to make a full contribution ($190,000 to $220,000 to make a partial contribution). But you don't have to worry about any of this with a 529 plan, because no income limits apply. The age of the beneficiary also limits the use of a Coverdell ESA. You can't start a Coverdell ESA for any beneficiary who's age 18 or older, because you can't make any contributions to a Coverdell ESA after the beneficiary reaches age 18. The exception is if the beneficiary is a child who has special needs. This typically means that you can't keep adding to the kitty once your child's in college, since most children are at least 18 when they start college. And a Coverdell ESA that you have properly established cannot continue after the beneficiary reaches age 30 (unless the beneficiary has special needs). By contrast, the federal government imposes no age restrictions on 529 plans. However, a minority of states impose such restrictions of their own (usually only on 529 prepaid tuition plans), so make sure to check with your plan administrator. The tax treatment of Coverdell ESAs and 529 plans is generally similar. At the federal level, there is no deduction for contributions made to a Coverdell ESA or a 529 plan (though states may offer one). And withdrawals from both a Coverdell ESA and a 529 plan that are used to pay the beneficiary's qualified education expenses (called qualified withdrawals) are free from income tax at the federal level (but see the last section for an explanation of a sunset provision that affects 529 plans). At the state level, whether the withdrawal is income tax free depends on the state you live in (however, states that exempt 529 plan earnings from income tax may offer this tax benefit only if you participate in that state's 529 plan). Withdrawals from a 529 plan or a Coverdell ESA that are used for purposes other than the beneficiary's qualified education expenses (called nonqualified withdrawals) aren't treated as favorably. First, you'll pay income tax on the earnings portion of the withdrawal. For 529 plans, the person who receives the distribution (typically the account owner) pays the tax, while for Coverdell ESAs, the beneficiary generally pays the tax. Second, you'll pay a 10 percent federal penalty on the earnings portion. Plus, depending on the state you live in, you may also owe an additional state penalty on the earnings portion. As the account owner of a 529 account, you decide when withdrawals will be made and for what purpose. You're also free to change the designated beneficiary, and as long as the new beneficiary fits the definition of a qualified family member of the previous beneficiary, you won't be penalized for making the change. As a parent or guardian, you generally have these same rights with a Coverdell ESA, but the exact degree of control may depend on the trustee's policies. For example, control will sometimes pass to the beneficiary once he or she is no longer a minor. And when the beneficiary (who is not a beneficiary who has special needs) turns age 30, the funds in a Coverdell ESA must be distributed within 30 days. The earnings may be subject to tax and penalty, and the beneficiary will have control of the funds. By contrast, the money in a 529 account can generally stay there as long as you like (though prepaid tuition plans may have restrictions on how long an account can remain open). In terms of investment control, though, Coverdell ESAs have the edge. You can set up a Coverdell ESA with any number of banks, mutual fund companies, and other institutions. And you can customize your portfolio, choosing investments on your own. You're also typically free to move money among a company's investments or to transfer your Coverdell ESA from one trustee to another as often as you like. Finally, you can take a withdrawal from your Coverdell ESA and roll it over to a Coverdell ESA with a different trustee. The new account can be for the same beneficiary or for a new one within the same family. You can only do one rollover per year, though, and you must complete the rollover within 60 days to avoid tax and penalty. By contrast, you lack such investment freedom with a state savings plan, though the trend is for state savings plans to offer more investment choices and flexibility. If you're lucky, at the time you join a state savings plan you'll get to choose one or more investment portfolios offered by the plan, which typically consist of mutual funds tailored to different investment styles. Otherwise, your contributions will automatically go into a single investment portfolio based solely on your child's age. In either case, though, you don't get to choose the underlying mutual funds held in an investment portfolio--the plan's professional money managers make those decisions. And you can't move money from fund to fund within the portfolio that you have. Once you've invested money in a portfolio, you have limited opportunities to change investment options if you're unhappy with the portfolio's investment performance. Depending on a plan's individual rules, some plans may let you direct future contributions to a different portfolio. As for your existing contributions, some plans may let you change the investment option once each calendar year without changing the beneficiary, or they may let you change the investment option anytime you do change the beneficiary. But there's one option that's mandated by federal law and not subject to a plan's discretion. You can change the investment option on your existing contributions without penalty by doing a rollover to another 529 plan (state savings plan or prepaid tuition plan) without changing the beneficiary. However, you're limited to one such rollover every 12 months. If you want to do more than one rollover in a 12-month period, you'll need to change the beneficiary to avoid a penalty and taxes. Note: With a 529 prepaid tuition plan, your money is generally invested in a trust fund that's managed by professional money managers. You don't get to choose a portfolio, and you have virtually no say in how your money is invested. But you are typically guaranteed a minimum rate of return. You may be concerned about the gift tax consequences of contributing to a 529 plan or a Coverdell ESA. The treatment will be similar in both cases--your contribution is considered a completed gift to the account beneficiary, and so it qualifies for the annual federal gift tax exclusion. This means that you can gift up to $11,000 a year, per person, to an unlimited number of people without triggering federal gift tax. (Note: For 529 plans, you can increase this amount to $55,000 if you make no additional gifts to that beneficiary for the next four years.) And the fact that you're making a completed gift generally means that those funds are removed from your taxable estate. Keep in mind, though, that because the annual maximum contribution allowed to a Coverdell ESA is $2,000, you won't trigger the gift tax rules if this is your only gift to the beneficiary for the year. The federal financial aid treatment of Coverdell ESAs and 529 state savings plans is identical. Each is considered an asset of the parent if the parent is the account owner (which is a more favorable result than if the account were classified as a student asset). Also, distributions (withdrawals) from either a Coverdell ESA or a state savings plan that are used to pay the beneficiary's qualified education expenses aren't classified as either parent or student income, which means that some or all of the money is not counted again when it's withdrawn. However, the federal government treats 529 prepaid tuition plans differently. A prepaid tuition plan isn't counted as an asset of either the parent or student, even if the parent is the account owner. But withdrawals are counted. Specifically, any distributions (withdrawals) from a prepaid tuition plan reduce the cost of attendance at your child's college. The result is a reduction in your child's financial need--and thus financial aid--on a dollar-for-dollar basis. This is similar to the way the federal government treats scholarships and other gifts, such as a grandparent's direct payment of tuition. Because distributions from a prepaid tuition plan are handled this way, they aren't classified as either parent or student income on the federal government's aid application. Yes. You can open both a Coverdell ESA and a 529 account for the same beneficiary. And you can contribute to both types of plans in the same year for the same beneficiary. However, if withdrawals are made from a Coverdell ESA and a 529 account in the same year for the same beneficiary, you'll need to allocate the qualified education expenses you're covering between the two accounts. For more information, consult an experienced tax professional. Certain beneficial features of Coverdell ESAs and 529 plans are scheduled to sunset, or expire, in future years. The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Tax Act) that raised the annual contribution limit for Coverdell ESAs to $2,000 is scheduled to expire on December 31, 2010 . Unless Congress acts, after this date, the annual contribution limit for Coverdell ESAs will revert to $500--the limit that was in effect prior to January 1, 2002 . Similarly, the provisions of the 2001 Tax Act that made qualified withdrawals from 529 plans tax free at the federal level will expire on December 31, 2010 . Unless Congress acts, after this date, the federal tax treatment of 529 plans will revert to the law in effect prior to January 1, 2002 --the earnings portion of qualified withdrawals will be taxed at the beneficiary's rate. By contrast, no such sunset provision affects the federal tax treatment of Coverdell ESAs--qualified withdrawals will continue to be tax free at the federal level after December 31, 2010 . Click here to have us contact you to discuss your specific situation. |
|
||||||
| (877) 4-Be-Wise TEL | (877) BeWise-1 FAX Information on this site may not be published, rewritten, or redistributed without written consent from Women Be Wise. |
Home | Disclaimer | Copyright ©2005 Arika Larson | |||||
