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Ask the Advisor: Back to School Basics of the Coverdell ESA and 529 College Savings Plan

By Guest Blogger(view all posts by Kent_Thune)
at 9:41AM Thursday July 22, 2010
under Personal Finance

Question: What it is the best way to save for college?

This is quite a timely question, not only because back-to-school time is almost upon us but also because the tough economy has forced state government support for schools to decrease significantly, which makes for higher increases in college tuition.

In other words, if you can possibly save a few extra dollars, there has never been a more important time to save for college than now.
Before You Save for College

Before saving for college, assuming you are saving for one or more of your children and not yourself, keep in mind that your kids can always borrow to pay for college but you can't borrow to save for retirement. You must, therefore, keep your priorities straight and be sure a few items are funded properly before funding little Joey's college fund: Basic items to fund first are your retirement, life insurance policies and emergency fund. It is also wise to be sure your consumer debt (e.g.; credit cards, auto loans) is at a manageable level.

There are several ways to save for college, but let's hit the two major types of accounts: The 529 Plan and the Coverdell Education Savings Account.

The 529 Plan

A 529 Plan is an education savings plan operated by a state and is named after Section 529 of the Internal Revenue Code, hence the name "529 Plan." You don't have to live in a state to invest in its 529 Plan, but most states offer tax incentives that only apply if you invest in your state's plan.

Similar to a Roth IRA, the contributions are not deductible against federal income tax but your savings grow tax-deferred and withdrawals are not taxable at the federal level if used for college expenses.

There are two basic types of 529 Plan: Savings Plans and Prepaid Plans:
  • Savings Plans are similar to a 401(k) with regard to investing contributions in a pre-set selection of mutual funds or similar investments, from which you may choose. The account value can go up or down, depending upon the type of investment(s) you select.
  • Prepaid Plans work as the name implies: They let you pre-pay all or a portion of college costs.
The 529 Plan has no income or age restrictions and most states allow contributions up to $300,000.

Coverdell Education Savings Account (ESA)

The Coverdell ESA, like the 529 Plan, does not allow for federal tax deduction but does offer tax-deferred savings and tax-free withdrawals if used for college costs. The basic similarities between the two popular college savings vehicles, however, end there. Here are some key differences to help you in deciding which college savings account is best for you:
  • The ESA is not sponsored by a state; anyone can open one and they are most commonly offered (and most easily accessible) through large mutual fund companies, such as Vanguard and Charles Schwab.
  • The maximum contribution per year for the ESA is only $2,000. The key caveat here is that several accounts can be open for a single child; however, the total contributions cannot exceed $2,000 per year for any given child. For example, Grandma can open and account and contribute $1,000 per year and one of the parents can open an account and contribute $1,000 per year.
  • The ESA is more flexible: For example, you can use it for elementary and secondary school expenses in addition to college.
These are only the basics on the two accounts. There are other things to consider, such as benefits specific to The 529 Plan in your state or other considerations, such as how any of the plans affect other tax benefits, especially the Hope or Lifetime Learning credits, or how the withdrawals might affect financial aid. In addition, some of the benefits of the Coverdell ESA are set to expire at the end of 2010, unless Congress acts and renews the benefits.

For more valuable information on college savings plans, I highly recommend educating yourself further at SavingforCollege.com.

Kent Thune is a Certified Financial Plannerâ„¢ and owner of an independent, "fee-only" investment management firm in Mount Pleasant, SC. Kent is also a freelance writer. To read more of his work or to find out how to contact Kent, please visit his blog at The Financial Philosopher. Have a question? Email AsktheAdvisor@savings.com.


Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.