Cloverdell ESAs and 529 Plans are great ways to save for college. The investments can grow tax-free in stocks, mutual funds, bonds, and variety of investment vehicles.
However, these savings plans may impact financial aid and needs-based scholarship eligibility. Therefore, most financial advisors recommend that parents max out their 401k and IRA contributions before contributing to educational savings plans.
A Coverdell education savings account is a tax-advantaged investment account designed to encourage savings to cover future education expenses (elementary, secondary, or college), such as tuition, books, and uniforms (for the same year as the distribution).
Income limitations: Parents cannot contribute if their adjusted gross income exceeds $110,000 (single) or $220,000 (joint).
Maximum contributions: $2,000 is the maximum contribution per year per child.
Required age distributions: Balances in a Coverdell ESA must be disbursed on qualified education expenses by the time the beneficiary is 30 years old or given to another family member below the age of 30 in order to avoid taxes and penalties.
Qualified educational expenses: tuition, room and board; fees, books, supplies, and computer-related technology equipment. Covers K–12 public, private, religious school tuition, colleges and universities.
Financial aid: When applying for federal financial aid, the ESA account is considered an asset of the account custodian, typically the parent.
Tax destructibility: All contributions are after-tax. However, the investments will grow tax-free. No taxes will be owed if the distributions are made for qualified education expenses.
A 529 plan is a tax-advantaged investment vehicle designed to encourage saving for the future higher education expenses of a designated beneficiary.
In 2017, K–12 public, private, and religious school tuition were included as qualified expenses for 529 plans along with post-secondary education costs with passage of the Tax Cuts and Jobs Act.
There are two types of 529 plans:
- Prepaid plans (less common): Prepaid plans allow one to purchase tuition credits at today’s rates to be used in the future. Therefore, performance is based upon tuition inflation.
- Savings plans (more common): Savings plans are different in that all growth is based upon market performance of the underlying investments, which typically consist of mutual funds..
Maximum contributions: There are no maximum annual contribution limits; however, annual contributions over $14,000 ($28,000 if married) may trigger a gift tax return filing requirement. You can make lump-sum contribution of $70,000 ($140,000 if married) to cover five years without having to file a gift tax return.
Required age distributions: There is no age limit for distributions in most states.
Qualified educational expenses: Tuition, room and board; fees, books, supplies, and computer-related technology equipment. Covers K–12 public, private, religious school tuition, colleges and universities. A prepaid 529 will usually only go toward tuition and fees.
Financial aid: When applying for federal financial aid, the 529 account is considered an asset of the account custodian, typically the parent.
Tax destructibility: Contributions are state tax deductible, depending on the state. There is no federal tax deduction. However, the investments will grow tax-free. No taxes will be owed if the distributions are made for qualified education expenses.
What happens if your child doesn’t go to college?
Under either a Coverdell ESA or 529 Plan, you can change the beneficiary without penalty. The beneficiary can be any member of the family.
If your child does not go to college or trade school and you’re not able to designate another beneficiary, there will be a 10% penalty tax on earnings for non-qualified distributions.
What happens if your child gets a scholarship?
If a child receive a scholarship, you can withdraw up the the amount of the scholarship without having to pay a 10% penalty.