EDUCATION TAX CREDITS

 

Coverdell Education Savings Account (ESA) and 529 College Savings Plan were both developed to help pay for future college expenses. What are they and which one may be right for you? Continue reading and you will find out.

COVERDELL ESA

Formerly know as the Education IRA, contributions are not tax deductible, but withdrawals for qualified education expenses are tax free. In     other words, your contributions grow tax free. Qualified expenses generally include tuition, room, board, books, lab fees, and computers. Be sure to check your 529 plan for more details.

There are income eligibility limits. Contributions phase out for single taxpayers with adjusted gross incomes(AGIs) between $95,000 and $110,000. For married couples the limits are from $190,000 to $220,000.

You may contribute a maximum of $2,000 annually per child before the designated student reaches 18. Contributions are subject to the gift tgax rules.

There is no limit to the number of accounts that can be opened or the number of people opening an account in a specific childs name.


529 COLLEGE SAVINGS PLAN

The 529 plan owner makes contributions to the account and can assign a beneficiary to receive the money once they reach college age. The plan and money stay in the owner’s name until the money is withdrawn by the beneficiary for educational expenses.

The assets held in your 529 plan can be transferred without penalties to another family member to use for their education. This means my wife and spouse can open accounts under our name and change the beneficiary to our child after he or she is born. We could also elect to use the 529 College Savings Plan for our own educational costs should we wish to.

Contributions are made with after tax dollars, as with the Coverdell ESA . However, there may be certain tax benefits for 529 plans depending on which state you live in and in which plan you participate. Withdrawals from a 529 College Savings Plan is tax free if it is used for qualified higher education expenses. Qualified expenses generally include tuition, room, board, books, lab fees, and computers. Be sure to check your 529 plan for more details.

DIFFERENCES

Similarities. These college savings plans both work similar to Roth IRAs – contributions are non-deductible and grow tax free. Withdrawals are also tax free for qualified higher education expenses. 529 Plans and Coverdell ESAs are viewed the same for financial aid purposes. They are considered the assets of the custodian (the person who opened the account), and withdrawals by the beneficiary are not considered taxable income when used for college expenses. Both plans can be transferred to another beneficiary without penalties or fees.

Differences. The major differences between the 529 Plans and Coverdell ESAs are listed below.

Types of accounts:

  • 529 Plan: Two – Prepaid college tuition and savings plan
  • ESA: Only one

Control of account:

  • 529 Plan: Account holder controls when withdrawals will be made and for what purpose, and can change beneficiaries at will. There are no restrictions regarding when funds must be used.
  • ESA: Account holder can change beneficiary at will. If money is not transferred to a new beneficiary or used for higher education costs, then the beneficiary receives the assets when they turn 30 and the account will be assessed taxes and penalties.

Age limit for contributions and withdrawals:

  • 529 Plan: None.
  • ESA: Must be under 18 to receive contributions, must use assets before age 30.

Contribution limits:

  • 529 Plan: Between $100,000 and $350,000 depending on state
  • ESA: $2,000 per year from all sources

Income limits for contributors:

  • 529 Plan: No income limit.
  • ESA: To qualify for the max $2,000 contribution, your AGI must be less than $95,000 for single filers and $190,000 for married couples. Contributions will drop to $500 per year in 2010 if Congress does not extend the current limits.

State tax deductions or credits for contributions:

  • 529 Plan: Yes, depending on state plan and residency.
  • ESA: No.

Uses for plan assets:

  • 529 Plan: Higher education only.
  • ESA: Through 2010 assets can be used for K-12 and higher education.

Investment options:

  • 529 Plan: Stocks, bonds, mutual funds, CDs. Can only change investment allocation 2 times per year.
  • ESA: Stocks, bonds, mutual funds, CDs. No limit to changes in investment allocation.

 

Which is Better?

The 529 Plan is a more versatile plan, especially if you will have other people contributing money toward your child’s education – the $2,000 limit for ESA contributions is more difficult to track when there are multiple people contributing.

The Coverdell does have several advantages, including the ability to use the funds for K-12 (through 2010 unless extended), make unlimited changes to asset allocation, and ESAs may have better investment options, depending on the state in which you open your 529 College Savings Plan.

The good news is that you can have both plans for your children and you can roll a Coverdell ESA into a 529 College Savings Plan. As these are complex, please consult your investment advisor before deciding which one is right for you.