Saving for College: Coverdell Education Savings Account or 529 College Savings Plan?

Getting a head start on saving for your child’s college education is an important step in parenthood. The cost of college tuition is rising at such an alarming rate that it's often a good idea to start planning for college as soon as your child is born. Starting early allows more time for the account to grow and provide you with more financial assistance as your child grows.

Two popular tax-advantaged investment vehicles dedicated to covering a child’s future educational costs are the Coverdell Education Savings Account and the 529 Education Savings Plan.

Coverdell Education Savings Account

A Coverdell Education Savings Account (ESA) is very much like a Roth IRA. Contributions are made with non-deductible post-tax income and are gradually phased out starting at income levels of $190,000 to $220,000 per couple ($95,000 to $110,000 for single filers). Withdrawals are tax-free for qualified education expenses starting from kindergarten to the end of college for the child (beneficiary).

The annual contribution limit for a Coverdell ESA is $2,000 per child. You can contribute to the account until the beneficiary (your child) reaches the age of 18. The entire balance of the account must be withdrawn by time the child turns 30 years old. The custodian of the account may transfer any remaining balance to another beneficiary or the remaining balance will be paid out to the original beneficiary but it is subject to income tax and a 10% penalty tax.

The major selling point for Coverdell ESAs is the wide range of investment options available, including stock, bonds and mutual funds. Coverdell ESAs can be opened at many banks, credit unions and brokerages.

529 College Savings Plan

A 529 College Savings Plan is an investment vehicle administered by the state or higher education institution where contributions are not tax deductible for federal tax liability. Many states do offer state income tax deduction for all or part of the contributions.

Withdrawals are tax-free for qualified college expenses. Parents can withdraw non-qualifying funds but the amount would be subject to income tax and a 10% federal tax penalty.

The major selling point for 529 plans is that there is no direct annual contribution limit but the custodian should be aware that there is a gift tax for contributions in excess of $13,000. The total account size limit varies depending on the state. Age restrictions do not exist on 529 plans.

A major disadvantage of 529 plans is the lack of control over investments. Not all kinds of investments are available (they are dictated by the program) and the configuration of your asset allocation can be changed once per year.

In both investment vehicles, neither education savings vehicles are reported as the beneficiary's assets, and the beneficiary can be changed to another member of the current beneficiary’s family. Both Coverdell ESAs and 529 plans are counted as assets of the parent when determining eligibility for financial aid.

Which One to Choose?

The Coverdell ESA is versatile when it comes to investment options but suffers from many limits. A 529 plan doesn’t have as many restrictions but the investments may not fit your tastes.

There is no rule stating that you can only choose one. It isn’t uncommon to have a Coverdell ESA and a 529 plan. You may choose to contribute the maximum possible towards the Coverdell ESA and put the rest in a 529 plan. Remember that the Coverdell ESA can be used to pay educational expenses starting from kindergarten while the 529 plan is solely for college.