Smart Saving for School: 529s vs. Coverdell


We’ve all heard horror stories about students who graduate from college with $200,000 in debt, and whose monthly loan checks could cover the cost of a nice house in most Midwestern cities. Worse yet, we’ve all seen reporters asking recession grads about how they plan to meet this staggering expense. In many cases, the answer is moving back home to Mom or Dad and losing the opportunity to network with other young professionals in their career or city of choice. These future accountants, reporters, and software engineers will be forced to delay buying homes, starting families, and saving for their retirements. Most will make student loan payments well into their fifties. If you have a child with potential, and you have the ability to save even a little bit of money for his or her education, doing it now could make a lifetime’s worth of difference to your child later.

Fortunately, the government provides a number of tax benefits to ease the cost of higher education. In addition to the Hope and Lifetime Learning Credits and the deduction for student loan interest, two tax-preferred savings accounts can help you prepare for Junior’s romp through astrophysics or existential philosophy: the 529 plan and the Coverdell Education Savings Account. These two accounts produce similar tax benefits. Although you cannot deduct contributions to them, your investments grow inside of the accounts tax free, sort of like a Roth IRA. Withdrawals from both accounts are tax-free if they are used to pay for education expenses, and they are taxable if they are used to pay for something else. In addition, withdrawals used to pay for something other than education—a keg party, let’s say—are penalized at a rate of 10%.

The first type of account, called a “529 plan” or a “qualified tuition plan,” is sponsored by states or individual colleges and universities. It allows you to either (1) pay your student’s tuition in advance or (2) save money in an account on her behalf. The contribution limits are determined by the individual plan sponsors and can sometimes be in excess of $200,000, which should be more than enough to carry your budding organic chemist through undergraduate and grad school.

The prepaid tuition option is generally more limited than the savings account option. For instance, some states limit prepaid tuition to residents who have children under the age of 18. Why choose this option? There are two reasons. First, by paying in advance, you can avoid future tuition increases. In addition, most states will guarantee your child’s tuition even if the investments in your account turn out to be real losers. For risk-averse parents who are sure that their child will attend college in state, the prepaid tuition option provides definite security.

The savings option is more freewheeling than the prepaid tuition option. Unlike the prepaid tuition option, it generally has no age limit, so the beneficiary could be literally anyone, including yourself, your spouse or your parents. In addition, it generally has no residency requirement, which means that you can shop all 50 states for the plan that best fits your investment profile. Unlike the prepaid tuition option, the savings option does not lock in today’s tuition price. But it does allow you to choose your own investments. If your portfolio outperforms tuition increases at your child’s college of choice, your child will have more money for books and other expenses than if you’d chosen the prepaid tuition option. Finally, the savings option is better for parents who just aren’t sure where their child will attend college. There are generally no penalties or hang-ups associated with using the savings option to pay for out-of-state tuition.

Finally, the 529 plans come with a whole host of state tax benefits. Of course, to claim them, you usually have to enroll in your state’s plan, and the available benefits vary by state. The most common one is an income tax deduction for contributions to the plan, which can be very valuable if you reside in a high-tax state like New York or Massachusetts.

But wait, there’s more. Congress also provides tax-free growth inside of Coverdell Education Savings Accounts. Like 529 plans, these accounts resemble Roth IRAs. Unlike 529 plans, however, Coverdell accounts can be used to cover not only college tuition but also the expenses of K-12 education, including school uniforms, after-school tutoring and daycare programs. Private, public and religious school expenses are all eligible. In fact, the Coverdell account can even cover the cost of your family’s computer and Internet access, as long as the beneficiary of the account is a child in school who uses the computer. (Of course, only educational software is included, so don’t walk into BestBuy (Stock Quote: BBY) with your kid’s Coverdell money and walk out with World of Warcraft. (Stock Quote: ATVI) Finally, you can even use money from a Coverdell account to make contributions to a 529 plan!

The federal limitations on Coverdell accounts are generally more strict that the state limitations on 529 plans. First, the beneficiary of a Coverdell account must be a child under the age of 18. Second, each Coverdell kid can only receive account contributions of $2,000 each year, even if multiple accounts are established in his name. Third, if you earn more than $110,000 per year as a single person or $220,000 per year as a married couple filing jointly, you are not eligible to contribute to a Coverdell account. (But don’t let that stop you. Give $2,000 to Junior and have him open an account in his own name.) Finally, any unused money in a Coverdell account must be distributed to the account beneficiary within thirty days of her thirtieth birthday.

One last point. Both 529 plans and Coverdell accounts permit tax-free rollovers to family members. If you establish an account for Ted but he wins a full tuition golf scholarship, you can roll the money over to an account for Susie, who didn’t make the cut in soccer. This works for any family member of the beneficiary, including the beneficiary’s spouse, children, step-children, foster children, grandchildren, sisters, brothers, nieces, nephews, parents, aunts, uncles, first cousins, and even in-laws. You could even start a 529 account for yourself and later pass it to your children. With such generous rollover provisions, there is almost no chance that your education savings will go to waste, so why not start today?

Don’t forget to check out our complete archive of Daily Deductions.

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