For parents looking to invest in their children’s future by getting a jump-start today on saving for college expenses, there are two primary college savings plans you should get familiar with: a Coverdell college savings plan vs 529—both tax-advantaged programs used for education expenses.
So what’s the difference between Coverdell and 529. What are the potential tax deductions and how do you know which to choose to ensure the best financial plan for your child’s future? Let’s take a look!
What is a Coverdell ESA College Savings Plan?
A Coverdell Education Savings Account (ESA) is a popular tool parents can use to start saving for their child’s education. It was first introduced as the Education Individual Retirement Account (IRA) back in 1997 but has since been renamed in 2001 with new benefits.
A Coverdell ESA is a custodial account made in a child’s name that accepts up to $2,000 each year in after-tax contributions, which can be withdrawn tax-free for education expenses. Qualified expenses include room and board, tuition, books, and other qualified school-related fees.
Additionally, an ESA college savings account permits contributions to grow tax-deferred. This means that you can hold off on paying taxes on the account until you withdraw from it, putting time on your side and allowing the investment to grow without having to pay taxes on it.
Tax-deferral can also be beneficial if you’re currently in a high tax bracket now and believe that you will be put in a lower tax bracket in the future when it comes time to take out the money.
One caveat to be aware of when investing in a Coverdell ESA is that money not used by the time your child is 30 years old must either be given to them or rolled over to a Coverdell ESA for a different family member.
So who stands to benefit most from investing in an ESA college savings plan? If you meet a few of the following factors below, a Coverdell ESA may be ideal for you.
- You want to start planning early for your children’s college fees
- You have more than one child who you expect to attend college
- You care about flexibility when it comes to your investment options
- Your income falls below the max income limits for contributors—$220,000 for married couples and $110,000 for single filers
What is a 529 College Savings Plan?
You may be wondering, “Is Coverdell the same as a 529?” Nope! While they certainly have their similarities, they also have their differences.
A 529 college savings account is just that—a savings account for college (and K-12 education) leveraged by parents or grandparents to save for their child’s future education expenses. This account type is popular due to it being completely exempt from taxes. In fact, roughly 30% of college savings are in 529 plans, with the average amount being saved doubling from $2,820 in 2016 to $5,441 in 2018.
This state-sponsored plan gets its name from section 529 of the federal tax code and was first established in 1986 as a prepaid tuition plan by the Michigan Education Trust. Currently, there are two types of 529 plans: a prepaid tuition plan and a savings plan.
The prepaid tuition plan allows you to pay upfront for your child’s tuition costs at participating schools at today’s price. So if college prices rise, which they tend to do, the cost for tuition and fees you pay is already locked in and won’t change. This can provide families with big savings and peace of mind. It’s also backed by the state.
Just keep in mind that many prepaid tuition plans offer a limited enrollment window each year. Additionally, many will require the beneficiary to be a resident of the state sponsoring the plan.
A savings plan is a tax-advantaged investment that works similarly to an IRA. It allows you to invest your contributions in a variety of portfolios and mutual funds, so your account may increase or decrease, depending on the investment performance.
How are 529 Plans and Coverdell ESAs Alike?
Now that we’ve reviewed what each plan is, let’s take a closer look at how these two plans are alike. In the next section, we’ll look at the difference between Coverdell and 529 so you can make the most informed choice.
To start with, both plans require a parent or grandparent to name a beneficiary—that is, the child for whom you’re saving the money for.
The money in both plans can be transferred to a different person without paying taxes on it as long as that person is a relative of the previous beneficiary. So if your first child receives a scholarship that will pay for college costs or if they decide to forgo higher education altogether, the funds in your 529 or Coverdell ESA plan can be transferred to your second child, for example. The money and tax benefits won’t be lost.
Another way in which the two plans are alike is when it comes to the Free Application for Federal Student Aid (FAFSA)—both plans are treated equally. In short, FAFSA is a government-required form for applying to any kind of federal student aid, such as grants, student loans, and work-study programs. Neither the>529 savings plan or Coverdell plans will harm your child’s chances of receiving this financial aid since they aren’t considered assets. Sounds good, right?
Another key similarity between a Coverdell ESA vs 529 is that both allow the money in them to grow tax-free and neither are taxed upon withdrawal as long as the funds are used for qualified education expenses, otherwise, you’ll be required to pay a 10% penalty for either plan.
How are 529 Plans Different from Coverdell ESAs?
The biggest difference between Coverdell and 529 plans is how the money is invested. With an ESA college savings plan, investment options are plentiful. From stocks and bonds to mutual funds, ESAs offer more flexibility than 529 plans, which limit you to whatever investments are offered by the state.
Investments aside, 529 plans also differ from Coverdell ESAs when it comes to contribution amounts. Unlike a Coverdell ESA plan which limits the total amount you can contribute for a beneficiary to $2,000 a year, with a 529 plan, you can contribute up to the current gift tax exemption amount—which is $30,000 for married couples and $15,000 for single filers, as of 2019.
There are also some contribution restriction differences between the two plans. With a Coverdell ESA plan, you’re not eligible to use it if your income exceeds $220,000 for a married couple and $110,000 for an individual filer. 529 plans, on the other hand, don’t have any income level restrictions.
Control of the plan is another distinction between a Coverdell ESA and a 529 plan. With the Coverdell ESA, the money must either be given to your child by their 30th birthday or transferred to a different family member. With a 529 plan, the funds and control of the plan are always in the hands of the donor and never the beneficiary.
Coverdell vs. 529: Which Type of Account is Better For Me?
Coverdell ESA vs 529, which to choose? If you’re still stumped on which plan is better for you in the long-run, let’s break it down.
Here are the pros and cons of each plan at a glance:
- Funds grow tax-free and aren’t taxed upon withdrawal
- There are no age limits for using it
- Withdrawals are good for college and K-12 education tuition and fees
- No income restrictions
- You can opt to pay upfront for college costs with today’s prices
- The plan can be transferred
- The parent has full control of the plan
- You can contribute to a 529 plan in another state
- Investment options are limited
- Non-qualified education expenses will incur a 10% penalty
- There is no discount on gifts
Coverdell ESA Pros
- Funds grow tax-free and isn’t taxed upon withdrawal
- High flexibility when it comes to investment options
- The plan can be transferred
Coverdell ESA Cons
- Plan funds must be used or transferred by the child’s 30th birthday
- There are income restrictions
- There is a contribution limit of $2,000 per year per child
- Non-qualified education expenses will incur a 10% penalty
As you can see, both plans have their advantages and their disadvantages, and some donors might find one plan more beneficial over the other based on these pros and cons.
A 529 plan, for example, may be considered the better option for higher earners since the Coverdell ESA has income restrictions. A 529 plan also makes more sense when considering the rising costs of college tuition and expenses. With a prepaid 529 tuition plan, parents are able to lock in today’s prices by paying upfront for tuition.
On the other hand, a Coverdell ESA can be a great option for those looking for a college savings plan that affords more control over investment options. Unlike a 529 plan which limits you to whatever investments are offered by the state plan, a Coverdell ESA is super flexible in what investments you can choose from.
While you may think that a Coverdell account or 529 are your only options to help save or invest for your child’s education costs, there is a 3rd option–the UTMA. A UTMA account is UNest’s preferred type of investment account for its flexibility and tax advantages. With UNest you can set up a UTMA account for your child in less than 5 minutes. Learn more about the advantages of a UTMA account here.