Most every new year begins with a set of New Year’s resolutions. Along with eating better, exercising and losing weight, parents and grandparents may also set their eyes on saving more for college. Every good intention can easily be side-tracked by too many choices. You have 529 Savings Plans, Tuition Prepayment Plans, various custodial accounts and Coverdell Education Savings Accounts. To help you let’s look at the key differences between 529 Plans and Coverdell ESA or Education Savings Accounts.
Coverdell Education Savings Accounts also referred to as ESAs used to be known as ‘Education IRAs.’ These have always lived in the shadow of the more popularly known 529 Plan. But tax law changes in 2012 made permanent certain tax benefits that make it easier to recommend to clients.
One of the key differences between a 529 Plan and a Coverdell ESA is the broader investment flexibility of an ESA and its expanded tax-free treatment for education. While dollars saved in a 529 Plan can be withdrawn tax-free for qualified higher education expenses, proceeds in a Coverdell ESA may be used for elementary and secondary school costs (K-12) as well.
The 2012 tax law changed rules initially set in 2002. These changes increased the annual per-child contribution from $500 to $2,000, continued allowing favorable distributions for K-12 expenses and allowed tax-free distributions for college expenses for a family claiming the Hope/American Opportunity Tax Credit or Lifetime Learning Credit.
Coverdell ESAs are well suited for families with other education costs to cover such as K-12 tuition. And Coverdell ESAs can also be ideal if a family is likely to only be able to save $2,000 per year per child.
If your child is young enough—not yet 18 years old—and your income is low enough (the income phase-out is $95,000 to $110,000 for a single taxpayer and $190,000 to $220,000 for a married couple filing jointly), you can contribute up to $2,000 per year to a Coverdell ESA for that child.
If your income is too high, first gift the ESA money to your child and have the contribution come from the child.
Understand Coverdell Limits and Differences
- Coverdell ESAs offer tax-free treatment for K-12 as well as college expenses.
- There is a $2,000 per child annual contribution limit for Coverdell ESAs, as well as income limits.
- Similar to an UGMA or UTMA account, assets in a Coverdell ESA are not revocable.
While a contribution to a 529 Plan can be changed to benefit a different child, ESA assets are not revocable. So in many ways a Coverdell ESA is like a UGMA or UTMA account. Unlike those custodial accounts though, the Coverdell ESA has a bank or other financial firm as a custodian but you as the parent are the ‘responsible individual’ who calls the shots on what to invest and when to distribute. This is very much similar to how your IRA works.
Money leftover in a 529 Plan can be reclaimed and used by anyone for any purpose though the account owner will pay the taxes and penalty for using it for any reason other than qualified education expenses. Or the 529 Plan account owner can name a different beneficiary including a charity allowing the funds to grow for a long time.
While 529 Plans offer this flexibility, a Coverdell ESA does not. If there are any unspent funds remaining in the account by the time the student is 30, then the funds need to be distributed and are subject to income tax and 10% penalty on account growth if there are no qualified education expenses in the year of distribution.
While a 529 Plan clearly allows an account owner to change the name of the account beneficiary, there is some confusion when it comes to a Coverdell ESA.
Federal tax law says the beneficiary can be changed to another family member below age 30 without triggering tax or penalty. But that runs counter to the notion that contributions were originally made for one particular child’s benefit. Some ESA agreements provide that only the current beneficiary, after reaching legal age, has the right to change beneficiaries.
Grandparents and Education Funding
A 529 is a much more flexible tool for grandparents and other relatives who want to help with education funding. Annual contributions to a 529 Plan are effectively limited only by the annual gift exclusion ($14,000 per year per beneficiary per grandparent in 2014). And any relative can open a 529 Plan for the same beneficiary without worrying about coordinating contributions.
This is not so for a Coverdell ESA which has a hard limit of $2,000 per year per child regardless of how many relatives want to contribute. Let’s say you drop $2,000 into an ESA for your child this year, and a grandparent opens another ESA with $1,000. The annual contribution limit has been breached and your child owes a 6% excise tax on the $1,000 excess.
Most, but not all, ESAs protect against this unfortunate result by requiring that a parent or legal guardian, and not the grandparent, be named as the responsible individual on any ESA set up for your child. So at least you as the parent will get a chance to notice the excess contribution and take it back out of the ESA before May 31 of the following year, thereby avoiding penalties.
But that still does not prevent your little Johnny from facing off with the IRS if a contributing grandparent violates the contributor income requirement, or sends the money in after Johnny turns 18.
Coverdell ESA Offers Broader Investment Choices
One clear advantage that a Coverdell ESA has over a 529 Plan is that you effectively have an unlimited menu of investment choices while 529 Plans are limited to an approved list much like your 401(k). This may be appealing to self-directed investors. On the other hand, not all financial firms even offer Coverdell ESAs. Several big name firms like Vanguard and T. Rowe Price have stopped offering them and Fidelity has never offered them.
No Tax Deduction for ESA Contributions
Another key difference between 529 plans and Coverdell Education Savings Accounts is that some states offer a tax deduction for contributions to 529 plans. This is not the case for contributions to an ESA.
Financial Aid Treatment Same as 529 Plan
For financial aid purposes there is no difference between 529 Plans and Coverdell ESAs when it comes to treatment of assets. When it comes to the financial aid formulas used by schools, both count the assets as parental assets which are assessed at a lower rate than assets held in the name of the student.
Funds Can Transfer to 529 Plans
One thing you should note is that you always have the option to transfer funds out of the Coverdell ESA into a 529 Plan as long as you keep the beneficiary the same and designate the new account as a ‘custodial 529 account.’ This road goes only one way. 529 Plan assets cannot be transferred to an ESA.
Finally, you should be aware of maintenance fees on ESAs as they have greater impact on low-balance accounts.
To sort through these various options and develop a proper game plan, consider calling in a qualified financial planner.
