529 Plan | Coverdell Plan

529 Plans

One option you would have is to change the beneficiary to another member of the family. That could be the current beneficiary's brother or sister. It could also be the beneficiary's cousin, although the cousin alternative will disappear at the end of 2010 unless Congress extends current treatment (which we expect to happen). You could even move the beneficiary up or down the family tree, naming the beneficiary's child, parent, or even yourself as replacement beneficiary.

Another option you have is to take the money back out of the 529 plan for yourself. However, you probably won't want to do this unless you have a real need for the funds. Any earnings growth in the account will be taxable to you at your ordinary income rate plus a 10-percent penalty rate. The fact that the account beneficiary can be changed as many times as you want means that any excess funds in your 529 plan can remain there to be passed down from generation to generation (check to see if your 529 plan has a restriction on how long the account can stay open—many do not).

Myth #2: If I'm a resident, my in-state 529 Plan will always provide in-state tax breaks.

Not necessarily. Some states do offer favorable tax treatment to their residents for participating in their own state-sponsored 529 Plan, such as state tax deductions up to a certain level for contributions and state tax-free withdrawals for qualified higher education expenses.

However, not all states provide in-state tax breaks for residents. In addition to state tax benefits, make sure you consider other factors when evaluating a 529 Plan, including investment choice and flexibility. Additionally, you may wish to consult with a tax advisor about state and local tax issues.

Myth #3: 529 Plan account assets can negatively affect my child's chances for financial aid.

Most federal financial aid formulas consider about 5% of parents' assets and 35% of a child's assets available for college.¹ Plans where assets are considered those of the parent, such as 529 Plans, tend to have a lower impact on financial aid than plans where assets are considered those of the student, such as a Uniform Gift to Minors Act (UGMA) account.

Keep in mind that grandparents' assets are not evaluated when calculating eligibility for financial aid. So, when a grandparent opens a 529 Plan account for the benefit of their grandchild, it has no affect on the child's initial evaluation for financial aid. For more information, you may wish to consult a financial aid advisor or a particular school's financial aid department.

Myth #4: I'm not eligible to open a 529 Plan account because I've already opened  an UGMA.

Families can establish a 529 Plan account even if they've already opened another college savings account, such as an UGMA. In fact, an appropriate college savings plan may include a combination of various investment vehicles. It should be noted that some 529 Plans allow the registration of an UGMA/UTMA 529 Plan account. One benefit to doing this is that the assets, once subject to the "kiddie tax," will now grow tax-deferred and are federal income tax-free 2 when distributed for a qualified higher education expense.

However, there are some potential consequences of opening  an UGMA/UTMA 529 Plan account. For example, the assets belong to the beneficiary and upon reaching the age of  majority,  the beneficiary can use the assets for any purpose. Also, you may not change the beneficiary on  an UGMA/UTMA 529 Plan account, and since UGMA/UTMA 529 Plan account assets belong to the beneficiary, the beneficiary may not receive favorable financial aid treatment.

Myth #5: If I invest in a 529 Plan account, I have very little choice and flexibility with respect to my investment options.

Many 529 Plans have a wide variety of  investment options to choose from, including age-based portfolios, static portfolios, and individual fund portfolios. Certain plans, such as the Fidelity Advisor 529 Plan, provide more flexibility than others with respect to the number of options they provide and your ability to select any age-based portfolio, regardless of the beneficiary's age. While you're only allowed to reallocate previously invested contributions and earnings among portfolios once per calendar year for a given beneficiary and upon the change in designated beneficiary, 529 Plans allow you the flexibility to change the investment allocation of future contributions at any time.

Myth #6: I can split my accelerating gifting up over two years.

The 529 Plan accelerated gifting provision allows an individual to make a gift of up to $55,000 (or $110,000 combined for spouses who gift split) to each beneficiary per year without triggering the federal gift tax. This requires that no further gifts be made to the beneficiary over the five-year period and that the gift is treated as a series of five equal annual gifts. You may not conduct accelerated gifting over multiple years, i.e., you may not gift $25,000 in 2003 and $30,000 in 2004. Whatever the gift, you must pro-rate the dollar amount over the five years. Assuming your goal is to have no federal gift tax impact, for each year you can only contribute the difference between the annual gift limit ($11,000) and what you have already given that year.

Coverdell Plans

Myth #1: Coverdell accounts remain tax-free after 2010

As most 529 plan investors know, the current federal tax exclusion on qualified 529 withdrawals expires at the end of 2010. It is anticipated that Congress will ultimately act to extend the exclusion beyond the year 2010, there are no assurances.

Many investors figure they do not have to worry about this problem with Coverdell accounts since their tax-free status for college purposes predates the 2001 Tax Act and its 2010 "sunset" provision. What these folks may not realize is that the old law exempted Coverdell account withdrawals only for taxpayers who chose not to claim the Hope or Lifetime Learning credit. Just about everyone was better off with the credit than with exemption of Coverdell account earnings.

Because of the sunset, this situation is scheduled to return in 2011, and those of us using Coverdell accounts for college will once again be forced to give up the Coverdell account exemption to claim the more valuable credit. We can only hope that Congress does the right thing so that families using either 529 plans or Coverdell ESAs don't have to pay tax on qualified withdrawals.

Myth #2: Coverdell accounts are less expensive than 529 plans

Many 529 plans impose asset-based program management fees, and some also impose fixed-dollar, annual account-maintenance fees. Although Coverdell accounts generally don't charge a separate asset-based fee, most do charge annual account fees. Because the amount that can be invested in an Coverdell account is limited to $2,000 per child per year, the affect of these fees on your investment return can be greater. A $20 annual account fee on a $2,000 Coverdell account balance is equivalent to a 1 percent expense ratio.

Coverdell account costs could rise even further in the future as the IRS has made the record-keeping burden extraordinarily difficult for the Coverdell account administrators. Some mutual fund companies and brokerages such as Fidelity don't even offer Coverdell accounts, while some others do offer Coverdell accounts but require that you maintain a substantial balance in their other investment products to assure a profit.

Many states offer special tax breaks to residents using their own 529 plans, and these breaks can more than offset the program-level fees and expenses. By investing in your own state's 529 plan, you may be eligible for a tax deduction, a matching contribution or some other valuable incentive. You don't get these benefits with a Coverdell account.

Myth #3: Coverdell accounts are less confusing than 529 plans

Admittedly, the plethora of state-crafted 529 plans, along with their unique tax characteristics under federal and state law, can make the choice and use of 529 plans a rather confusing process. But Coverdell accounts also have some issues, even though they all follow the same basic model.

Record keeping is one of the problems. The IRS may have figured it was doing everyone a favor when it recently switched the burden of maintaining Coverdell account tax-basis records from the investor to the plan provider. But the midstream change of direction is creating a record-keeping quagmire. For certain rollovers and taxable distributions, you will need to know the tax basis of your Coverdell ESA. Some investors, through no fault of the Coverdell account administrator, will not have the correct information.

Then there is the issue of excess contributions. Let's assume Dad decides to use the Coverdell account and plunks down $2,000 for his 4-year old daughter. But Grandma also wants to help, so she puts $2,000 into a separate Coverdell ESA for granddaughter. Together they have exceeded the annual contribution limit. Unless they somehow recognize the problem and retract the $2,000 excess contribution in time, the poor preschooler will be responsible for reporting and paying a 6 percent excise tax. That could lead to a restless naptime. The same problem occurs with contributions made by taxpayers who discover too late that their adjusted gross incomes exceeded certain limits.

Myth #4: You can maintain control with a Coverdell account

Many parents have set aside funds for college using Uniform Transfers to Minors Act (UTMA) accounts. The risk you take in establishing an UTMA is that your child gains direct control of the investment at a particular age established under state law, typically 18 or 21. With a Coverdell account, that particular problem appears to go away. The federal tax law permits a Coverdell account to remain under your control, provided you are designated the "responsible individual," until the Coverdell account beneficiary reaches age 30, at which time the balance must be paid out to the beneficiary. You can also change the beneficiary of the Coverdell account at any time to another family member under age 30.

But lawyers familiar with this area say the whole concept of Coverdell account control is a fuzzy one. Questions of property ownership are decided under state laws, we're told, not federal tax law. But one thing is clear: The Coverdell account must be used for the benefit of the named beneficiary, and not for you, the donor or responsible individual. A 529 savings plan affords the ultimate level of control, placing no restrictions on your ability, outside of tax and penalty consequences, to use a withdrawal for whatever purpose you choose.

Myth #5: Coverdell accounts offer more investment flexibility

Actually, this is not a myth. You can have a self-directed Coverdell ESA, whereas a self-directed 529 account is not allowed. The myth may be that greater investment flexibility is a good thing. That will depend on your (or your financial adviser's) ability to select and maintain an investment portfolio appropriate to your education-savings objective. The portfolios available in most 529 savings plans are designed for that one objective.

Myth #6: Coverdell accounts offer a good financial aid result

The good news is that the U.S. Department of Education recently came out with a notice stating that Coverdell accounts will now receive the same favorable treatment that 529 savings plans receive in determining eligibility for federal student aid. In years past, the Coverdell account was disadvantageously considered the student's asset. The bad news is that the Education Department's former position makes more sense than their current position (see Myth No. 4 above). Coverdell account investors can only hope that the Education Department doesn't do another flip-flop.

Conclusion: The Coverdell account can be an excellent way to save for education costs, either alone or in combination with other investment alternatives. Just be sure you understand its risks and limitations.