Thursday, August 23, 2012

College Savings


So you’re saving 15% of your annual income towards retirement.  Now what?  If you have children, now is the time to start saving for their college education.  There are two main options to consider; the 529 and the Coverdell Education Savings Account.  Which one is right for you?  Below is a brief description of each plan along with the major pros and cons.

The Coverdell ESA


According to the IRS,”A Coverdell ESA is a trust or custodial account created or organized in the United States only for the purpose of paying the qualified education expenses of the designated beneficiary of the account.”  That is a long winded way of saying it’s a college savings account. It is named after Senator Paul Coverdell (now deceased) who sponsored the legislation creating the Education Savings Account.

Coverdell ESA Pros and Cons:

Pros:
  • The earnings in the account grow tax-free and withdrawals are always tax free as long as they are used for eligible education expenses.
  • Available investments in ESA are the same as those for an IRA (almost anything) making the ESA more flexible than a 529.
  • The money is not considered an asset of the child when applying for financial aid.
  • A new beneficiary can be designated without incurring any tax penalty as long it’s transferred to an eligible family member(which is almost anyone remotely related to you.  Check out the IRS website here for the list).
        Cons:
  • Contributions are limited to $2,000 a year for each child. 
  • The beneficiary will eventually take control of the money at the age of the majority (18 or 21 depending on the state you live in). 
  • Income limits prevent single tax filers earning more than $110,000 and married tax filers earning more than $220,000 from contributing to a Coverdell ESA.  However, a nice little loophole exists.  You can gift the $2,000 to your child who can then open an ESA for themselves.
  • The funds must be used by the time the beneficiary is 30 to any tax penalties.

The 529

According to the IRS, a 529 plan is “a plan operated by a state or educational institution, with tax advantages and potentially other incentives to make it easier to save for college and other post-secondary training for a designated beneficiary, such as a child or grandchild.” 

There are two types of 529 plans:
                 
Prepaid Tuition:

According to the SEC, “Pre-paid tuition plans generally allow college savers to purchase units or credits at participating college and universities for future tuition and, in some cases, room and board. Most prepaid tuition plans are sponsored by state governments and have residency requirements.” Since there is no guarantee where a child will go to school, this strategy can be risky. Also, the fees of these plans can be very high since someone (i.e. – you) has to pay for the risk of rising tuition costs.
                 
Savings Plan:
Simply put, the 529 Savings plan is an investment  account for the purpose of paying eligible expenses.

529 Pros and Cons:

Pros:
  • Like the Coverdell ESA, the earnings in the account grow tax-free and withdrawals are always tax free as long as they are used for eligible education expenses.
  • Also like the Coverdell ESA, a new beneficiary can be designated without incurring any tax penalty as long it’s transferred to an eligible family member.
  • Contribution limits are loosely defined by the IRS in the following way; “Contributions cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary.”  This essentially means you can contribute as much as you like but be mindful of the $13,000 gifting rule.
  • At no time does control transfer to the beneficiary as it does with in ESA. The account owner maintains control of the money. 
  • There are no income restrictions; everyone is eligible to take advantage of a 529 plan.
  • The money is not considered an asset of the child when applying for financial aid.
  • Most state 529 plans do not have residency requirements.  You are free to shop for the 529 that best suits you. 
Cons:
  • The money must be used for college, university, vocational school, or other postsecondary educational institution or you will pay ordinary income tax as well as a 10% tax on the earnings.
  • 529 fees can be high.  Checking the fees should definitely be on your checklist prior to choosing a plan.
  • Investment options can be limited as compared to the Coverdell ESA and you are only able to move investments once every 12 months.

We are saving for our children’s college educations by saving $2,000 into a Coverdell ESA and then anything above that into a 529.  I like the ability to invest in whatever I choose as great benefit of the ESA while the lack of contribution limits of the 529 allow for college savings above and beyond $2,000.  How are you saving for college?