529 vs Coverdell: Saving for College

529 Plan Basics

529 plans have been around for over 20 years and are a commonly used college savings tool, with 30% of college savers using them.^[2] A 529 plan is a type of education savings plan designed to provide benefits for both the saver and the beneficiary. 529 plan funds can be used for qualified education expenses.

There are no income level or age restrictions with a 529 plan, and anyone (parents, grandparents, and other relatives) can open and fund a 529 plan account. You can even open up a 529 account for yourself to pay for educational expenses, and designate yourself as the beneficiary. Keep in mind though that because 529 plan contributions are considered a gift, the donor is subject to the federal gift tax filing requirement above the limit. For 2019, the gift tax limit is $15,000, so anyone can contribute up to $15,000 to a 529 plan without having to file a gift tax return to the IRS.

Almost all states offer a 529 plan, but you don’t have to invest in your own state’s plan. It may make sense for you to shop around, as some states offer tax benefits to in-state contributors, while other states provide state income tax deductions or credits for contributing to their 529 plan. And since 529 plans are administered by the states, there may be varying contribution limits and other factors that come into play.

Investing with a 529 Plan

With any 529 plan, you can choose the asset allocation to determine how the funds will be invested.

Like any investment, the longer the time horizon, the more opportunity there is for growth. For example, if you start saving for your child’s college costs soon after birth, you’ll have about 18 years before your child needs to use those funds.

When you create a 529 account for a young beneficiary, the account will typically be invested more aggressively (meaning there is a higher tilt to equities than to fixed income). As the beneficiary gets older and closer to entering college, that asset allocation may shift to more conservative investments, such as fixed income, US Treasuries or cash.

Benefits of Using a 529 Plan

One of the biggest perks of using a 529 plan for financial planning is the tax-deferred growth and tax-free withdrawals. When used for qualified education expenses, you won’t pay federal taxes on any earnings in your account. This is unlike a regular brokerage or investment account, where you would pay a capital gains tax on any growth that you would see in the account. Distributions from a 529 plan account would also be exempt from federal taxes if the money is used for qualified education expenses.

Also, you can now use up to $10,000 of your 529 plan funds per year to pay for certain non-college education tuition and fees, such as elementary through high school education at private, public, or religious schools. Not all states have gone along with this change though, so it’s important that you review the state laws where your 529 plans are invested. We recommend that you discuss educational expenses with your advisor and tax professional to avoid paying any unintended state-level taxes.

Have a high-achiever who doesn’t need the college savings?

You can change the beneficiary of your 529 plan account to another qualified family member—someone who has some sort of relationship to the designated beneficiary. Check the IRS website for a full list of qualified beneficiaries. You can also roll over or transfer the funds to another 529 plan. With a rollover, you must move the funds within 60 days of the distribution. 529 plan accounts don’t expire, so the funds can be passed on to other generations and beneficiaries.

Worried about how your 529 plan accounts will impact your child’s financial aid?

There’s a lot of complexity around financial aid, so it’s common for parents and students to feel anxious about the process. The Free Application for Federal Student Aid (FAFSA) is the most commonly used form for families seeking financial aid for college, including grants, loans, and work-study programs. From the information you provide as a family on the FAFSA form, schools will get to an estimate called the expected family contribution, or EFC, which they use to determine a family’s financial need.

For the most part, an investment in a 529 plan will have minimal impact. The EFC formula takes into account a range of 2.6%-5.6% of the parents’ assets to calculate a family’s financial need.^[3] Assets in a 529 plan, where the parents are the donor/owner, are typically counted as an investment in this calculation. This means that up to 5.6% of the 529 plan value will be applied to the EFC.

Withdrawals from a 529 plan can also get murky when it comes to how it impacts financial aid. With a parent-owned 529 plan account, withdrawals are not reported as income on FAFSA. However, if a grandparent or a relative owns a 529 plan account and the child receives a distribution from the 529, this must be reported as student income on the FAFSA, and may impact the child’s financial aid package.

Coverdell Education Savings Accounts

Another tool you can use for college savings is the Coverdell Education Savings Account (ESA). While both 529 plans and Coverdell ESAs can be used to help pay for education costs, there are a few important distinctions. The key differences between these two savings options are contribution amounts, contribution restrictions, and investment options.

• Contribution amounts. Unlike a 529 plan where a donor can contribute up to the gift tax exemption amount without having to file tax paperwork ($15,000 in 2019 for an individual and $30,000 for a married couple), a Coverdell ESA limits the total amount contributed for any one beneficiary to $2,000 per year. (Note: You can front-load these gifts as well, also known as “superfunding.” The IRS allows you to contribute up to five years’ worth of contributions at once ($75k per person or $150k for a married couple) and avoid gift tax consequences. If you choose this option, you will need to complete a Form 709 gift tax return.)
• Contribution restrictions. With a 529 plan, there are no income level restrictions for contributions. With a Coverdell ESA, if your adjusted gross income exceeds $110,000 for an individual, or $220,000 for a married couple filing a joint return, you’re not eligible to use a Coverdell at all.
• Investment options. A benefit to using a Coverdell ESA is the ability to self-direct specific investments. While you can choose an asset allocation in a 529 plan, you are limited to the investments that the state-sponsored plan offers. With a Coverdell ESA, you can pick specific investments you like, which is a great option for donors who prefer to have more control over the investment offerings.
• Tuition vs Expenses. Regarding elementary and secondary schools, the important distinction between a 529 plan and a Coverdell ESA is how tuition and expenses are handled. A 529 plan, when used for elementary and secondary schools only, is limited to tuition, while a Coverdell ESA can pay for elementary or secondary school expenses as well.

It’s never too early to start financial planning for college for your loved ones. The sooner you begin, the more time you have to take advantage of the tax-deferred growth. We encourage you to speak with your advisor about how we can help you make sense of college savings.

Want to learn more about saving for educational expenses?

Listen to our podcast “How to Fund College Without Going Broke” where our advisors discuss how to make the right choices for college funding.

Footnotes:

[1] “Price of Attending an Undergraduate Institution,” National Center for Education Statistics.
[2] “How America Saves for College,” Sallie Mae, 2018.
[3] “Financial aid basics,” Savingforcollege.com.