College Savings: Coverdell Education Savings Account Vs. 529 Plan

So, your little angel has graduated. The dream has come true. 

They are finally getting the hell out of your house. 

Let’s be real, though. They  aren’t going to last a second out there among the piranhas. You’ll sleep a little easier if you can give them a little leg up. To that end,you may want to start a college savings account.

Planning for college is tricky. Especially where your taxes are concerned. Here’s what you need to know.

There are two types of accounts that you can open to help your child graduate without a crippling amount of debt. 

  • Coverdell Education Savings Account 
  •  529 Plan Account

You can reduce your decision between these account options to two accounts to one question: Do you want control over your investment options or tax-free contributions? 

Coverdell Education Savings Account 

A Coverdell Education Savings Account is set up to cover a child’s secondary education. The growth on your contribution is tax-deferred until the funds are spent. If they are spent on education, they are tax-free.

There is no tax deduction for the amount you contribute to a Coverdell, but you have some fantastic investment options and you can opt to self-direct. The rules are similar to those that cover an IRA.

 Coverdell has the following rules and benefits:

Coverdell Rules

  • There are zero federal or state income tax deductions on Coverdell accounts.
  • Parents (or grandparents) can contribute without limitations to a Coverdell until a beneficiary reaches age 18 if the contributor has income of $190k (married joint) or $95,000 (single).
  • Your child can always contribute to their own account with gifted funds (no need to have earned income).
  • Funds can be used for tuition, fees, books, and equipment for college as well as certain K-12 expenses.
  • $2,000 annual contribution limit per beneficiary (e.g. child or grandchild).
  • Contributions grow tax-free and can be withdrawn for education until your beneficiary reaches 30 years old. 
  • Unused surplus can be transferred to another family member. 

Coverdell Benefits

  • Accounts can be invested into stocks, mutual funds, and can even be self-directed. Similar to an IRA.
  • Contributions grow tax-free and can be withdrawn for education expenses until the account beneficiary reaches age 30. Unused amounts can be transferred to another family member beneficiary.

529 Plan Account

The 529 Plan is invested in a state-managed fund and may be eligible for a state income tax deduction (contributions are tax deductible in 35 states). Money contributed to your 529 Plan account is invested into a state managed fund. A 529 has the following rules and benefits:

529 Rules

  • Money can be withdrawn for tuition, fees, books, supplies, equipment, special needs, room and board.
  • There are no federal tax deductions or credits for contributions.
  • Up to $300,000 can be invested per beneficiary by any person.
  • Money is invested into a state run program.

529 Benefits

  • Many states (hopefully yours) offer tax deductions for contributions to 529 Plan accounts. Thirty-five states offer some type of state income tax deduction for 529 Plan contributions. However, there are some states, like California, who offer no tax deduction for contributions to 529 Plan accounts.
  • Your money must be invested solely into state run programs. There are no other investment options.

College Savings Account Recap

Planning financially for college can be tricky, especially when it comes to taxes. As you can see, the main difference between the two accounts is that Coverdell accounts have the benefit of allowing you to decide how your contributions will be invested, but the money is not tax deductible.

On the other hand, contributions to a 529 Plan account must go to a state run fund, but that money is usually eligible for tax deductions.

 

Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.

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