Coverdell Education Savings Accounts Vs 529 Plans For College Savings

Posted by Michael Kitces on Wednesday, May 8th, 11:06 am, 2013 in Taxes

Over the past decade, 529 college savings plans have been the dominant vehicle for those trying to save and invest for college. The combination of tax-free growth, high contribution limits, generally reasonable expenses, and more favorable financial aid treatment than outright gifting money to children through a UGMA/UTMA account, have all added to the appeal. While alternatives have been available - like Coverdell Education Savings Accounts - the appeal was limited, due both to the relatively small contribution limits, and the potential for some of the most favorable Coverdell rules to sunset at the end of 2012 with the fiscal cliff.

With the American Taxpayer Relief Act fiscal cliff legislation making Coverdell accounts permanent, though, it is perhaps time to give them a fresh look. Unfortunately, their contribution limits remain modest compared to both what can be contributed to 529 plans, and simply the cost of college itself, so Coverdell accounts may still only be part of the college savings picture for many clients in the foreseeable future - especially given that many states provide state tax deductions or credits for 529 plans but not Coverdell accounts. Nonetheless, Coverdell Education Savings Accounts represent one of the only opportunities to save tax-free for elementary and secondary school, and in some cases may even be lower cost than 529 plans due to their greater investment flexibility. As a result, it may be time to start considering them more proactively as a potential planning tool for certain client situations.


529 College Savings Plans

A 529 plans - or technically, a Qualified Tuition Program under Section 529 of the Internal Revenue Code - allows for the investment of contributions that will grow tax-deferred inside the account, and are available tax-free for qualified higher education expenses (e.g., tuition, room and board, fees, books, supplies, and equipment including computers). 529 plans are sponsored by individual states, although there is no particular restriction to use a plan in any particular state; however, some states do provide modest state credits or deductions to incentivize residents to select a home state plan. 529 plans generally come in two broad types: 1) the 529 prepaid tuition plans, which allow you to pay for future years of college at today's rates (essentially guaranteeing at least a growth rate equal to inflation); and 2) 529 college savings plan, where contributions are allocated by the account owner amongst a specified list of available investment options, and the future account balance - whatever it does or does not grow to - is available to pay for college expenses. 529 college savings plans generally only allow beneficiaries to change their investment choices once per year (or when there is a beneficiary change), although age-based asset allocation funds that become steadily more conservative over time are popular (alleviating some of the need to make ongoing investment changes).

529 plans have no contribution limits, beyond limits imposed by individual plans to ensure that contributions are not materially greater than the amount that would ever be necessary to fully fund college; these limits vary depending upon the plan and the state involved, but are typically several hundred thousand dollars. From a practical perspective, most individuals find contributions limited by the current gift tax laws (up to $14,000/year, although a maximum of $70,000 can be gifted to a 529 plan in a single year and averaged out over the next 5 years) before the plan limitations become relevant. 

There is no maximum age for contribution, nor a maximum age for funds to remain inside a plan. Funds in a 529 plan that are not needed for a beneficiary can be used for another beneficiary who is a family member of the original beneficiary. If the money is ultimately not used for eligible educational expenses, any growth is taxed as ordinary income, and subject to a 10% penalty. 

For financial aid purposes, assets in 529 plans are treated as an asset of the parents, regardless of whether they are owned by the parent or a child (although if the child is not a dependent, the account will be treated as an asset of the child). If a 529 plan is owned by a grandparent, it is not included in the evaluation for financial aid at all, but this potential "loophole" was recently closed by requiring that distributions from a non-child-or-parent 529 plan be reported as income of the beneficiary (although this only applies for the FAFSA and not necessarily for school-specific financial aid).

Coverdell Education Savings Accounts

The basic structure of Coverdell Education Savings Accounts is fairly straightforward: contributions are invested, growth within the account is tax-deferred, and if ultimately spent on higher education expenses, the distributions are ultimately tax free. However, contribution limits are modest - especially compared to 529 plans - at only $2,000/year for an individual child/beneficiary. In addition, eligibility for contributions phases out for individuals as AGI rises from $95,000 to $110,000 (or from $190,000 to $220,000 for married couples; these amounts are not indexed for inflation), although contributions on behalf of a child could be made by a grandparent, or even gifted to a child to contribute on their own behalf, to navigate around the contribution income limitation; in any event, though, the maximum contribution from all sources on behalf of that child remains $2,000/year, as the limit is per-beneficiary, not per-contributor. 

Once the child turns 18, contributions can no longer be made, and the account must be spent or liquidated by the time the child turns 30. If the money is not spent for qualified educational purposes, growth is taxable as ordinary income, and subject to a 10% non-qualified distribution penalty (with withdrawn for nonqualified purposes or due to automatic termination at age 30). And unlike 529 plans, a funding a Coverdell account cannot be undone; once the gift is made, the gift is irrevocable, which means if a nonqualified distribution will occur later, it must be to the beneficiary, not back to the original donors. However, contributions can be rolled over to another family member of the previous beneficiary (as long as the new beneficiary is also under the age of 30!), and funds can also be rolled into a 529 plan for the beneficiary to avoid the age limitation. There are no Federal (nor currently, any state) tax deductions or credits for contributing to Coverdell accounts.

There are two important distinguishing characteristics for Coverdell accounts, though. The first is that contributions are invested in a brokerage account, where the Coverdell status simply serves as a tax-favored wrapper for the account - similar to an IRA - which means the account owner has all the flexibility of the typical investment account to allocate the money, including investing in individual stocks and bonds, or any selection of mutual funds or exchange-traded funds, and they can be changed at any time; by contrast, 529 plans restrict investment choices to the offerings listed under the 529 plan, and account owners are generally limited to changing investments only once per year. (Of course, in some situations the restrictions on investment flexibility and frequency of investment changes can protect account owners from self-inflicted harm!)

The second distinguishing characteristic of Coverdell accounts is that tax-free distributions can be spent not only on higher education expenses, but also on certain K-12 expenses as well. This opportunity to use withdrawals for elementary and secondary school expenses, like tuition or a computer for school, provides a unique opportunity for tax-free saving for private "prep" or parochial school expenses that is simply not available through 529 plans, which can only be used for college-related expenses.

From a financial aid perspective, Coverdell Education Savings Accounts are treated as a parent's asset, regardless of whether the investment account is actually owned by the parent or the dependent child (although if the child is not a dependent, the account will be treated as an asset of the child). Notably, Coverdell accounts must be owned by the parent or child, though (unlike 529 plans); if grandparents are contributing, they still contribute on behalf of a parent's or child's account.

Notably, many of these provisions, including the contribution limits, income thresholds, and eligibility to use the funds for tax-free distributions to pay for qualified elementary and secondary school expenses, was scheduled to expire at the end of 2012, but was extended and made permanent under the American Taxpayer Relief Act of 2012

Coverdell Vs 529 - When To Use Each For Savings

Given the availability of both Coverdell Education Savings Accounts and 529 Plans for college savings, the question arises about when/whether to use each, especially now that the Coverdell rules have been made permanent (as the 529 plan rules already are). Or rather, given that the contribution limits are so low for Coverdell accounts (compared to both 529 plans, and the amounts necessary to save for college itself), is it still worth using Coverdell accounts at all?

One reason why some will still prefer to use Coverdell accounts is for their investment flexibility. In some cases, this may be due to a desire to invest in particular stocks or bonds - which isn't possible given the restricted list of fund-based investment choices available under 529 plans. On the other hand, for many investors the limited investment choices and "auto-pilot" age-based options may actually be preferable to ensure the account owner does not make poor behaviorally-driven investment choices. In other situations, the Coverdell account may be appealing simply because some ETFs have even lower costs than 529 plans, making them an appealing low-cost alternative, especially if contributions were not going to exceed $2,000/year anyway. (Of course, it's important to bear in mind that ETF purchases in Coverdell accounts may have transaction trading costs that offset some or all of the expense ratio savings, especially given the dollar amounts involved with $2,000 contribution limits; this effect can potentially be exacerbated by subsequent transaction costs to reallocate the account over time to make it more conservative.)

Another appealing reason for Coverdell accounts is not as an alternative to 529 plans, but a supplement to them, specifically to save for elementary and secondary school expenses. Of course, the reality is that contributing up to only $2,000/year for a young child to spend on elementary school expenses just doesn't allow for much time to compound tax-free growth anyway; however, some families may wish to save in a Coverdell account for anticipated private high school expenses, where contributions and growth thereon can compound for a decade or more. For instance, contributing $2,000/year for 15 years growing at 8% can generate more than $20,000 of tax-free growth to fund the last year or two of a private or parochial high school tuition bill. If the child ultimately doesn't need the funds for high school, the assets can still be used tax-free for college, or for another child's school expenses.

For many clients, the Coverdell account may not seem worthwhile, if the family is making contributions significantly higher than $2,000/year on an ongoing basis; even with potentially lower cost investments (albeit partially offset by potential transaction costs), the additional account and hassle may simply not be deemed worthwhile for the benefit. In addition, it's important to check if the client lives in a state that provides any state deductions or credits that would make the 529 plan more appealing than a Coverdell account. But arguably, for those who aren't contributing enough to exceed the limits (and where there is no state tax deduction or credit for a 529 plan contribution), a Coverdell may even be preferable as a lower cost option, especially on a platform that has little or no transaction costs (e.g., the Schwab OneSource platform for mutual funds and some ETFs), although there are a relatively limited number of current providers even offering such accounts. And perhaps, now that Coverdell rules are permanent, the available providers will expand as the accounts become more popular?

So what do you think? Do you ever use Coverdell accounts for clients? Would you consider them as a savings vehicle for private school expenses, or as a lower cost alternative? Are there any other situations you would consider a Coverdell account for clients? 


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