Families may want to consider multiple types of savings vehicles when deciding how to save for college.
Coverdell Education Savings Accounts, known as ESAs, are tax-advantaged accounts designed to help families save for elementary, secondary and college expenses. In many ways, these accounts operate similarly to 529 savings plans. A 529 plan, named for the section of the Internal Revenue Code that created it, comes in two varieties: a prepaid plan, which may be administered at the state level, and a savings account, which is typically linked to certain investments.
Until this year, one of the biggest advantages of Coverdell ESAs was that the funds in these accounts could be used beyond college expenses. Families could use these accounts to pay for their children’s private high school education, for instance. But the passage of the Tax Cuts and Jobs Act in December 2017 leveled the playing field. Now 529 account holders can use up to $10,000 per year to pay elementary or secondary school tuition for a beneficiary.
“I would imagine a majority of families saving for college use 529 plans as opposed to Coverdell ESAs, and that trend will only continue to accelerate with the passage of the Tax Cuts and Jobs Act,” says Ryan Firth, a certified professional accountant at Mercer Street, a Houston-based financial services firm.
[Read: Explore Pros, Cons of Using Coverdell Accounts for College Savings.]
It’s now harder to see the advantages of opening an ESA instead of a 529 plan, says Anderson Wozny, executive director at Edelman Financial Services in Fairfax, Virginia, who says investment flexibility is the biggest advantage of the ESA, given that ESA account holders have more options in terms of where they open the accounts and the types of investments they contain.
Another way these two savings vehicles are alike is that in each, withdrawals for noneducational expenses are subject to a 10 percent penalty under the federal tax code. Educational expenses under both types of accounts include tuition and fees, books and some room and board expenses.
Both ESAs and 529s also count as assets when a family is applying for college aid with the Free Application for Federal Student Aid, commonly called the FAFSA.
While 529 savings accounts and Coverdell ESAs share similarities, here is what parents need to know about the differences between these two types of tax-advantaged college savings accounts.
[See: 10 Things You Can Buy With 529 Savings Plan Distributions.]
Coverdell ESAs offer more investment flexibility. “With a Coverdell, you can open it at a bank, credit union, brokerage house, and you can pretty much invest in any type of individual investment. You could buy individual stock with it. You can buy CDs with it,” says Wozny.
An ESA account holder can invest in almost anything, including individual stocks and bonds, real estate investment trusts, mutual funds and exchange-traded funds.
Wozny likened 529 savings accounts to 401(k) plans, since 529 account holders are typically given a “limited investment selection.”
“Coverdells can be invested in traditional as well as alternative asset investments, such as real estate, whereas 529 plan contributions may only be invested in traditional assets, such as mutual funds,” says Adam Bergman, a tax attorney and president of the IRA Financial Trust Company, a financial services firm in New York City.
Coverdell ESAs are only available to families at a certain income level. Coverdells are designed for low-income and middle-class families, and contributions are tied to a phaseout schedule set by the IRS. The income limit for maximum modified adjusted gross income now stands at $190,000 for married couples filing jointly and $110,000 for single filers.
[See: 10 Advantages of Using a 529 to Pay for College.]
Income restrictions do not come into play with 529s. Also, it’s worth noting that contributions to either type of account — 529s or ESAs — do not qualify for a federal tax deduction, though several states do offer deductions for 529 plans.
Maximum investments are higher under 529s savings accounts. Coverdell ESAs have lower contribution limits — set to a maximum of $2,000 per year. “A parent contributing $2,000 each year to a Coverdell from when the child is born until the child turns 18, assuming a 7 percent [interest] rate, would have $72,758,” says Bergman.
In contrast, 529 savings plans typically have a set maximum balance established by the program, which varies by state and ranges from $235,000 to $520,000, Bergman says.
There are no age restrictions with 529 plans. Coverdell ESAs have age and other time restrictions for beneficiaries. Unlike a 529 account, which does not have age restrictions, contributions to an ESA must be made before the beneficiary turns 18. Additionally, the funds in the account need to be used before age 30.
“Exercise caution around the child who is planning on attending grad school, specifically if they are looking at medical school,” says Fisher, since medical students can remain in school until their early 30s.
Overall, Fisher believes “a 529 plan is ultimately the best route” for families looking to save for college.
Trying to fund your education? Get tips and more in the U.S. News Paying for College center.
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4 Ways Coverdell Educational Savings Accounts Differ From 529 Plans originally appeared on usnews.com
