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A few weeks ago, a FinanceSuperhero reader, Daniel, wrote in with a question about the best college savings option available for his young daughter. I’m grateful to Jeff Proctor, co-founder of VTXCapital and BreakingTheOnePercent, for sharing the scoop on Coverdell ESAs and 529 Plans in the guest post below.
College isn’t cheap- and I’m guessing if you’ve somehow found your way to this article, I’m not telling you anything you don’t already know.
For the 2016-2017 school year, the average in-state college tuition is expected to be $24,610. Private college? Yeah, that’ll be $49,320 (Source).
These are per year figures.
Assuming you are going to at least try to help front some of the costs for your child’s college education (even if you don’t plan on paying for all of it), saving and planning is an absolute must.
Sadly, barring any groundbreaking shifts in education policy/trends, tuition prices are only going to go up from here.
On the bright side, parents have a few different “tax-advantaged” options for saving for college. The two most popular types of college savings accounts are Coverdell ESAs and 529 Plans.
Coverdell ESAs and 529 Plans offer different benefits, so being familiar with each is important if you want to make the most of your college savings efforts.
First Things First- Don’t Put Off Saving for College Any Longer
Even if your child is already in high school and college is right around the corner, putting money aside now is infinitely better never doing it at all because you think it’s already too late.
Obviously, the earlier you can start saving, the better.
Some parents even open and begin contributing to their child’s college fund as soon as they are born! If you are in a financial position to get a head start on saving while your child is so young, please do.
The more time you have to let compound returns work in your favor, the more money you will have to put towards college expenses. Every dollar counts.
How to Choose Which College Savings Vehicle is Right for You
Coverdell ESAs and 529 Plans are great choices for college savings (and definitely better than just a regular savings account).
Both accounts are tax free when the funds are used for college expenses, which means that as the accounts grow, you will not be responsible for paying any income taxes on capital gains.
Perhaps the biggest different between each account type is the contribution limits.
Coverdell ESAs (Education Savings Account) have an annual contribution limit of just $2,000, whereas 529 Plans allow for each parent to contribute up $14,000 per year to avoid federal gift tax, per beneficiary (a.k.a. child). You can choose to put in more than $14k, but the beneficiary would have to pay gift tax, which defeats the purpose of putting the money in a tax-free account.
Despite the lower contribution limit for Coverdells, many families are still choosing to use them over 529s (or in addition to 529s). There are two big reasons for that:
- Coverdell ESAs allow for the account owner to self-direct the investments (similar to how you can pick your own investments in your IRA). This often means you can save money by choosing less expensive investments funds, and you have more flexibility overall with how the money is allocated. Some parents love this option and others are totally indifferent.
- Coverdell funds can be withdrawn tax-free for qualifying K-12 expenses in addition to college expenses (529s are strictly for college only). This option is especially attractive for parents that send their children to private school for K-12, as private school can be quite expensive.
Related Reading: Why College Isn’t For Everyone
Perks of the 529 Plan
All in all, 529 Plans end up seeing a lot more money poured into them than Coverdell ESAs.
In general, they are easier to work with and have fewer restrictions.
For instance, there is no income limit that would prevent parents from contributing to a 529. Coverdells, on the other hand, cap contribution ability to only those families with income under $220,000/yr (joint filers) or $110,000/yr (single).
And since the contributions limits per year are much higher, many parents would rather opt to keep things simple and contribute only to a 529 Plan. And speaking of simple, many parents also don’t at all mind using the pre-made investment options offered within a 529– not everyone necessarily wants to be able to self-direct their investments (like you can in a Coverdell ESA).
In addition to letting your account grow tax-free, many states even offer tax deductions for 529 contributions.
Coverdell contributions are not tax deductible in any state.
Some Other Neat Options within 529s
Many states have different rules on 529s, so I’m not able to cover all the nuances in this post. (Contact your accountant or investment advisor for state-specific nuances.)
For instance, in Virginia (where I currently live), there’s a pretty clever “loophole” that I have seen used many times by higher income families.
Virginia taxpayers who own a 529 account can deduct their contributions up to $4,000 per account, per year, with unlimited carry forward into future tax years.
Notice it says per account, not per beneficiary. So, in Virginia, it can be worth it to open multiple accounts for the same beneficiary. For all intents and purposes, the accounts would look identical (same investments, same size, etc). Doing this is purely for the tax break.
Other states may have similar tax breaks available to encourage saving for college, so it’s important to do your research or talk to a professional before you get started.
“Superfunding” a 529
For families that can afford to do this, superfunding is a great option.
Superfunding is a way to greatly increase the amount of money you can start a 529 with, without getting hit with federal gift taxes.
So, rather than contributing $14,000 or less per year in order to avoid paying federal gift tax, there is a special rule for 529s that allows for account owners to “pre-fund” an account with 5 years of contributions in advance.
That means that each parent can pre-fund up to $70,000 ($14,000/yr x 5 years). So, theoretically, parents can together start their child’s college savings fund with $140,000 and not have to pay gift tax.
Why is this a good thing?
If parents can afford to do this, it increases the amount of time that your money has to grow. Starting with a large lump sum at the beginning and letting time work in your favor will most likely mean higher overall returns over the long term.
Of course, parents considering this option would need to be absolutely certain they won’t need access to any of that money for anything besides college expenses, otherwise they will be hit with a 10% withdrawal penalty (which would easily negate any benefit gained).
With Both Coverdell ESAs and 529 Plans, Make Sure to Involve Your Child
After all, it’s their education you’re saving up for.
Transparency goes a long way.
Let your kids know how much you are planning to help. Show them some actual numbers.
For a child, being involved in saving for college is a great trial run for managing finances as an adult. It’s a great way to set the foundation that I think a lot of parents miss.
Whether it’s looking at a 529 account statement and learning how investing works, or understanding what the interest rates are on student loans, or how to find and apply for scholarships and being self sufficient (or even making extra money on their own), these are all valuable life skills.
Remembers, personal finance still isn’t being taught in most K-12 schools. It’s up to you, the parent, the take the lead on instilling smart money habits in your kids. Getting the ball rolling with Coverdell ESAs and 529 Plans is a great place to start.
Disclaimer: This article on Coverdell ESAs and 529 Plans is not meant to provide any tax, financial or accounting advice. It has been written for informational purposes only. You should consult with your own tax, financial or accounting advisors before engaging in any transactions.