Two of the most popular options remain the 529 Plan and Coverdell Account.
Both of these accounts allow for parents or guardians to save for college on a tax-deferred or tax-free basis. However, there are subtle nuances between the accounts that could make one a better choice for your savings needs. Understanding these differences could save you some headaches and potentially benefit a student over the long run.
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The reason why both Coverdells and 529 Plans make great savings vehicles is that they each allow for tax-deferred accumulation phases. Here, dividends, interest and gains are able to grow untouched by Uncle Sam’s hands and are not subjected to annual taxes. This allows for increased compounding. Those returns can be withdrawn tax-free as well, under certain conditions. Here, both accounts can allow for tax-free withdrawals when used for certain qualified expenses for higher education. And thanks to the Setting Every Community Up for Retirement Enhancement Act (SECURE Act), both accounts can now be used to pay for certain primary or private schools.
As for federal aid, both accounts count as parent’s assets on a FAFSA Form and can be used to gain higher aid requirements.
In the end, both Coverdell and 529 Plans allow families, grandparents and other guardians the ability to save for their children’s or other beneficiaries advanced education.
When looking at Coverdells, there are income limits, just like Roth IRAs. With these account types, the ability to contribute begins to phase out at $190,000 for joint filers and $95,000 for single filers. After $220,000 and $110,000, the ability to contribute to a Coverdell ceases. Secondly, there are limits to how much you can contribute in the first place. Coverdell accounts allow for each saver to place just $2,000 maximum per year into the vehicle. This amount is tied to a beneficiary. This means that they can only receive a total of $2,000 per year, no matter who has accounts for them.
Another quirk with Coverdell accounts is that they have an expiration date. Funds located within the account must be used by the time a student turns 30 or taxes, fees, and penalties will accompany withdrawals. Moreover, savers cannot change the beneficiary on the account.
So, why put up with these income restrictions?
The key to a Coverdell comes down to investment choice. These plans are set up at investment managers and function as brokerage accounts. Savers using a Coverdell have an infinitely large number of investment choices. Want to go basic? You can buy an ETF or mutual fund tracking the S&P 500. Feel the need to take on more risk? You can day trade biotech stocks to your heart’s content. With a Coverdell, the choice is yours. But keep in mind, because they are run by investment managers, it’s important to check under the hood and look at the range of fees associated with each account.
To start, 529 Plans have far greater contribution limits. These limits are based on the estimated total expenses for a student in that state’s system of higher education. This means that the total life-time limit is in the $300,000 to $500,000 range. Each year, savers can sock away upwards of $15,000 before triggering Federal gift tax rules. However, thanks to so-called prefunding exclusions, savers can place up to $75,000 in a 529 plan in a single year. Moreover, there are no income limits when it comes to 529 plans. Anyone can contribute to them.
Check out our state plans section here to know about the rules and regulations pertaining to each U.S. state.
Secondly, 529 plans can come with a series of tax benefits. Since they are sponsored by states, residents of a state’s plan can gain valuable state/local tax deductions. This can provide the coveted “triple tax” benefit of tax savings today, during compounding and during withdrawal phases.
However, that state sponsorship does come with a major drawback. Investors are forced to choose from the plan’s investment menu. That means if you want to trade a stock or buy bonds, you can’t. Most 529 plans offer a suite of master funds that own mutual funds or ETFs.
Perhaps the biggest benefit for a 529 plan is the ability to shift beneficiaries and no expiration limit. This allows families to potentially to push college savings into further generations and avoid taxes on gains and investments.
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