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529 Plan vs Coverdell ESA - Which Plan is Better to Save for College?

529 College Savings Plan and Coverdell ESA are popular college savings plans. Both can help you save for your child's education, but one may suit your needs better. In this article, we compare both.

529 Plan vs Coverdell ESA - Which Plan is Better to Save for College?

It's never too early to start saving up for your kid's college education. A college education isn't getting any cheaper. Having a savings plan in place will save you a lot of trouble when it comes to paying for college. It will also reduce the amount of student debt your kid accumulates, which can help them jumpstart their future career.

The Coverdell Education Savings Account and the 529 College Savings Plan are two of the most well-liked methods of saving for college. Both will assist you in saving money for your child's future education, but because they each have unique advantages, one may better meet your needs than the other. Knowing the details of Coverdell accounts and 529 plans can help you make an informed choice for your family.

Let's look at both of them in more detail to determine if either is a good option for your family.

The 529 Plan

A 529 plan is created specifically for saving for college. When it comes time to pay for your child's education, you can withdraw money tax-free and grow your money tax-free, making it operate much like a retirement account. There are no unforeseen charges or penalties if the money you are withdrawing is for educational costs. This is the most adaptable and cost-effective savings option for the majority of families.

Fun Fact: Section 529 of the IRS code, which permits college savings, is the inspiration for the name of 529 plans. Every state provides at least one 529 plan, and some offer multiple ones. Additionally, some universities run 529 Plans as well.

The two primary categories of 529 Plans are:

1. College Savings Plan

This investment strategy can be used to build up funds for future costs at any US college. You have the option of investing the funds you deposit into the account. Based on your income, investment objectives, and level of risk tolerance, you can select a suitable portfolio. The majority of states hire an impartial mutual fund company to manage 529 plans. They provide a variety of investment options, including stocks, bonds, and money market funds. Only once every 12 months are you allowed to change your investment portfolio. The 529 Plan rollover to a new beneficiary or switching from one state plan to another are the exceptions. Direct deposits are a convenient way to contribute to a college savings account. You designate a sum based on your savings plan to be deposited on a regular basis, and then put it out of your mind. You will benefit from this, especially if you are a sporadic saver. It's an easy way to start building your education fund that you can set and forget.

Note: Here at College Funding Hero, we focus on low-effort ways to save money. Do not worry if your income is low and you can only save a few dollars occasionally. The majority of plans don't have lower contribution caps, and if they do, the caps are typically very reasonable.

How Do You Use the 529 Plan?

To use your 529 plan, you don't need to live in that state. Living in California while selecting a 529 plan in Florida is possible. You are not limited to attending a college in that state if you use the state plan. More than 6,000 US colleges and more than 400 foreign colleges accept your specific 529 Plan. As long as the funds are used within the state, various states also provide tax advantages for their 529 plans.

For instance, you can deduct $2,000 from your contributions in Georgia. While some states don't allow any deductions at all, others permit higher deductions. Consult with a licensed financial advisor before deciding which state plan to use. (If you don't already have one, get in touch with Josh's affiliated business, Vincere Wealth Management.) Again, the investments in your account can grow tax-deferred thanks to the section 529 plan. As a result of not paying taxes on investment growth, your investments will grow faster. The beneficiary won't be required to pay taxes on funds if used for qualified educational purposes because the plan also permits tax-free withdrawals for qualified expenses.

2. The Prepaid Plan

With the help of this 529 savings plan, you can pay for future college costs at the going rate. Once your child enrolls in college, the state will cover the cost of college tuition if you make fixed payments over a predetermined period of time. A prepaid tuition plan can pay for as little as one semester or as much as four years' worth of tuition. Age restrictions apply to these plans, and you must reside in the state where the program is offered and attend school there. You can still enroll in an out-of-state institution, but you will then be responsible for paying the difference in costs between your savings and the higher tuition rates. The plan won't fully cover all of your out-of-state study-related expenses.

The Coverdell ESA

Additionally intended for educational costs, the Coverdell provides tax benefits. However, there are restrictions on the amount you can save annually, and this plan might not be adaptable enough to suit your needs. A Coverdell, however, is a great savings tool in certain situations; learning about this savings option guarantees you cover all your bases as you investigate your college funding options.

A Coverdell ESA permits after-tax contributions in the name of a child of up to $2,000 per year. Although these non-deductible contributions must be made in cash, tax deferral will allow them to grow. Money withdrawn for qualified educational expenses won't be taxed, but non-qualified withdrawals may be.

The tax is paid by the beneficiary. This benefit is available for qualified elementary and secondary education costs in addition to qualified higher education costs.

There are certain requirements to set up a Coverdell ESA:

What's the Difference Between a 529 Plan and a Coverdell Account?

Similarities between 529 Plans and Coverdell ESAs

  1. Both savings methods allow for tax-deferred growth in investments
  2. Qualified withdrawals are tax-free. This means that withdrawals made for the purpose of spending on educational expenses are not subject to federal tax. "Qualified" expenses include tuition fees, academic tutorials, books and supplies, computers, internet, other study expenses, and transportation. Any withdrawal for non-qualified expenses incurs taxation plus a 10% penalty.
  3. Both plans can be used to save up for primary and secondary school expenses and college expenses.

That's it for the similarities. 529 plans and Coverdell ESAs also have many differences that you should consider when deciding how to save for future college expenses.

Differences between 529 Plans and ESAs

1. Age Restrictions

Most 529 Plans have no age limits. Your child can still use 529 Plan money even when they are way past the student age. You can also make contributions to the account for as long as you need to. 

With Coverdell ESAs, you can only make contributions until the child is 18 years of age. Any contributions made after that are subject to an excise tax of 6%. A beneficiary also has to use the funds in their account by the time they reach 30 years of age. Funds left unused after this age incur taxation plus a 10% penalty. To avoid having remaining money in an ESA, you can transfer the funds to another younger family member's ESA.

2. Income Restrictions

529 plans have no income restrictions, so anybody can contribute. 529 Plans are, therefore, useful for high-income families. Coverdell ESAs have income restrictions depending on how much the contributor earns. Contributors with a Modified Adjusted Gross Income (MAGI) of less than $95,000 for single tax filers and $190,000 for joint tax filers can contribute up to $2,000. Contributors with a MAGI of between $95,000 and $110,000 (single filers) or between $190,000 and 220,000 (joint filers) can only contribute less than $2,000. Contributors with a MAGI of more than $110,000 (single filers) or $220,000 (joint filers) cannot contribute at all. ESAs, therefore, are not ideal for high-income families.

3. Contribution Restrictions

The 529 Contribution Limits: There are no annual contribution caps for 529 plans. For federal tax purposes, however, contributions to a 529 plan are regarded as completed gifts, and in 2022, a maximum of $16,000 per donor ($15,000 in 2021) and per beneficiary is eligible for the annual gift tax exclusion. Amounts over $16,000 must be reported on IRS Form 709 and will be deducted from the taxpayer's lifetime exemption from estate and gift taxes ($12.06 million in 2022).A larger tax-free 529 plan contribution can also be made if it is treated as though it were dispersed evenly over a 5-year period. In the event that there are no subsequent gifts made to the same beneficiary over the following five years, a lump sum contribution of $80,000 to a 529 plan, for instance, can be treated as though it were $16,000 per year. This 5-year gift-tax averaging technique is occasionally used by grandparents as an estate planning tool. Some 529 Plans also have a provision for making five years' worth of contributions in one year for a single beneficiary without incurring a gift tax. The higher limit is helpful because if you start saving late, you can still catch up with college expenses.

The Coverdell ESA Contribution Limits : Additionally, Coverdell has an annual contribution cap of $2,000 per participant. The maximum $2,000 contribution limit is phased out for single filers with modified adjusted gross income (MAGI) between $95,000 and $110,000, and for joint filers with between $190,000 and $220,000. No contribution is allowed once your MAGI reaches $110,000 for single filers and $220,000 for joint filers. You have until the due date of your return (not including extensions) to make a contribution and have it apply to the previous year. ESAs, on the other hand, are subject to restrictions on the amount of money contributed per year per beneficiary. Each beneficiary can only receive a maximum of $2,000 per year. Even if they have multiple ESAs opened for them by different people, the total contributions across all these accounts cannot exceed $2,000. And, $2,000 a year is sort of like shooting bb's at a freight train compared to the cost of college tuition.

4. Contribution Deadlines

529 plans have no contribution deadlines. ESA contributions for the previous year must be made before the tax-filing deadline for that year.

5. Financial Aid Eligibility

529 plans have a minimal effect on whether the beneficiary will be eligible for financial aid because they are considered the parents' asset. Therefore, only 5.64% of its value is counted against financial aid. ESA's effects on financial eligibility depend on the ownership of the account. If the child owns the account and is dependent on their parents, the assets will be counted against financial aid. If the child holds the account and is independent of their parents, 20% of the assets will be counted against financial aid. If the parents own the account, only 5.64% of the assets will be counted against financial aid.

Which is right for you?

The best plan for you and your family depends on your personal situation.

If you intend to use the account for college or other higher education costs, if you wish to use it for more than one child, and if you anticipate contributing more than $2,000 annually, a 529 plan might be the best option for you. Additionally, if you want friends and family to be able to contribute, it might be the better choice.

If you want to use the account to pay for elementary or secondary education costs, a Coverdell plan might be the best option for you, especially if you reside in one of the states where 529 plans cannot be used for this purpose. It might also be a wise decision if you only have one child and don't intend to contribute more than $2,000 annually.

Can you invest in both?

Yes. The same beneficiary may open both a Coverdell ESA and a 529 account. Additionally, the same beneficiary may contribute to both types of plans in the same year. In fact, it's challenging to imagine saving enough money for college using only Coverdell ESAs due to their low annual contribution cap. You must divide the qualified education expenses you are paying for between the two accounts if withdrawals from a 529 account and a Coverdell ESA are made in the same year for the same beneficiary. Consult a knowledgeable tax expert for more details. Before making an investment, investors should think about the investment goals, risks, fees, and expenses related to 529 plans; detailed plan information is available in each issuer's official statement. Investments run the risk of not performing well enough to cover college costs as expected.

Additionally, before making an investment, think about whether your state offers any tax advantages for joining a 529 plan and whether these advantages are conditional on doing so. The state may also provide financial assistance, scholarships, and creditor protection.

Wrapping Up

When all is said and done, a 529 Plan offers more investment and contribution options than an ESA. 529 plans have higher contribution limits and no age restrictions. They also have no income limits. They have the same tax advantages as Coverdell ESAs. 529 plans can cover you for more needs than Coverdell ESAs, so when considering a college saving plan, they are often the better option, especially for high-income families. However, you should consider the pros and cons of both to make a final decision. 

All the best!

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