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Saving for Your Child's Education: Coverdell Education Savings Account and Section 529 Plans Compared

Education Savings Options

The two easiest and most popular ways to save for your child’s education are putting money away into a Section 529 plan and/or a Coverdell education savings account.

A Coverdell Education Savings Account (ESA) is a tax-advantaged savings vehicle that lets you save money for the qualified education expenses of a named beneficiary, such as a child or grandchild. Qualified education expenses include college expenses and certain elementary and secondary school expenses.

There are two types of Section 529 plans—college savings plans and prepaid tuition plans.

  1. A college savings plan lets you save money in an individual investment account.
  2. A prepaid tuition plan pools your contributions with those of other investors and allows you to prepay the cost of college at today’s prices for use in the future.

Contribution Limits

The annual contribution limit for Coverdell ESAs is $2,000 per beneficiary. That’s considerably less than you can contribute to most 529 plans. So the more money you have to invest, the more attractive a 529 plan becomes.

Another potential drawback of the Coverdell ESA is that you may not be able to contribute if you earn over $95,000 a year, if you are a single tax filer. For joint filers, your annual modified adjusted gross income (MAGI) must be less than $190,000 to make a full contribution. You don’t have to worry about any of this with a 529 plan, because no income limits apply.

Age Restrictions

The age of the beneficiary limits the use of a Coverdell ESA. You can’t start or contribute to a Coverdell ESA for any beneficiary who’s age 18 or older. This typically means that you can’t keep adding money once your child’s in college, since most children are at least 18 when they start college. By contrast, the federal government imposes no age restrictions on 529 plans, which would be the ideal option for those who didn’t get an early start on saving.

Income Tax Treatment

The tax treatment of Coverdell ESAs and 529 plans is very similar. At the federal level, there is no deduction for contributions made to a Coverdell ESA or a 529 plan. Withdrawals from both a Coverdell ESA and a 529 plan that are used to pay the beneficiary’s qualified education expenses (called qualified withdrawals) will be not be subject to federal or California income tax.

Withdrawals from a 529 plan or a Coverdell ESA that are used for purposes other than the beneficiary’s qualified education expenses (called nonqualified withdrawals) aren’t treated as favorably. First, you’ll pay income tax on the earnings portion of the withdrawal. For 529 plans, the person who receives the distribution (typically the account owner) pays the tax, while for Coverdell ESAs, the beneficiary generally pays the tax. Second, you’ll pay a 10 percent federal penalty on the earnings portion, in addition to a possible state penalty on the earnings portion.

529 Special Gifting Feature

The treatment of gifted contribution will be similar in both plans—your contribution is considered a completed gift to the account beneficiary, and so it qualifies for the annual federal gift tax exclusion. This means that you can gift up to $13,000 a year, per person, to an unlimited number of people without triggering federal gift tax.

However, because the annual maximum contribution allowed to a Coverdell ESA is $2,000, you won’t trigger the gift tax rules if this is your only gift to the beneficiary for the year. 529 plans, however, offer a special gifting feature that’s not available with any other college savings vehicle. Specifically, you can make a lump-sum contribution to a 529 plan of up to $65,000, elect to spread the gift evenly over five years, and completely avoid federal gift tax, provided no other gifts are made to the same beneficiary during the five-year period. A married couple can gift up to $130,000. And the fact that you’re making a completed gift generally means that those funds are removed from your taxable estate.

Federal Financial Aid

The federal financial aid treatment of Coverdell ESAs and 529 college savings plans is identical. Each is considered an asset of the parent if the parent is the account owner (which is a more favorable result than if the account were classified as a student asset). Also, distributions (withdrawals) from either a Coverdell ESA or a college savings plan that are used to pay the beneficiary’s qualified education expenses aren’t classified as either parent or student income, which means that some or all of the money is not counted again when it’s withdrawn.

Questions?

We know that this was a lot of information to digest, so if you’d like to go over college saving options, please feel free to contact either of our CFS* Financial Advisors – Dennis Adams (415) 674-4845 and Stephen Seewer (415) 674-4846 are available to help answer your planning questions.

*Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (CFS), a registered broker-dealer (Member FINRA / SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. SF Fire Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.

CFS and its registered representatives do not provide tax advice. For specific tax advice please consult a qualified tax advisor. Investors should consider investment objectives, risks, and changes associated with Section 529 plans prior to investing. Contact your registered representative or carrier for more information about municipal fund securities which is available in the issuer’s official statement or plan disclosure document which should be read carefully prior to investing.