529 plans or education savings accounts: Which is best for your clients?

By Richard Nudelman, CPA, PFS, CFP
Berman, Goldman and Ribakow

There are a variety of enhancements to education savings plans that, depending upon your client's situation, can produce a significant impact on not only saving for college, but also on saving for elementary and secondary school expenses.

The most talked-about strategies in saving for college expenses are qualified tuition programs (commonly referred to as 529 plans) and the Coverdell Education Savings Account. By reviewing some of the differences between 529 plans and Coverdells, you can develop an effective strategy to suit your client's particular situation.

Background

Among other provisions, the Economic Growth and Tax Relief Reconciliation Act of 2001 provided for qualified distributions from 529 plans and Coverdells to be exempt from federal income taxes beginning in 2002. Also beginning in 2002, you may contribute to both a 529 plan and a Coverdell in the same year.

Contribution limitations

Contributions to a 529 are limited only by the maximum amount set by the particular state plan. Most state plans have maximum contribution limits in excess of $200,000 per beneficiary. The maximum annual contribution to a Coverdell is $2,000 per beneficiary.

Income limitations

There are no income limitations for making contributions to a 529 plan. However, only joint tax filers with modified adjusted gross income below $190,000 can contribute the maximum $2,000 to the Coverdell. This $2,000 is subject to phaseout between $190,000 and $220,000 of income. Joint filers with modified adjusted gross income above $220,000 cannot contribute to a Coverdell. (Single filer ranges from $95,000 to $110,000.)

Eligibility for state tax deductions

Many states offer a tax deduction to residents who contribute to their 529 plan. Maryland offers residents who contribute to its plan a maximum annual deduction of $2,500 per account holder per beneficiary. Contributions in excess of the maximum can be carried forward to future years.

There is no state tax deduction for contributions to a Coverdell.

Types of qualified education expenditures

Both 529 plans and Coverdells allow tax-free distributions that cover qualified higher education expenses. These expenses include tuition, fees, books, supplies and equipment required for enrollment and the reasonable cost of room and board for the period of time that the student is enrolled at least part-time.

The Coverdell also provides for tax-free withdrawals to cover qualifying elementary (including kindergarten) and secondary school expenses, which include tuition, fees, tutoring, supplies and equipment, room and board, uniforms, computer technology, Internet access and other related expenditures.

Change in beneficiaries

Both 529 plans and Coverdells allow the account holder or authorized individual to change the current beneficiary to a new beneficiary who is a family member of the beneficiary.

Investment options

A 529 savings plan limits the investor to the products offered by the particular state plan. A 529 prepaid plan does not offer investment choices, as you are purchasing tuition credits or units, thereby purchasing future tuition at today's costs.

Individuals who establish a Coverdell account can invest in mutual funds, stocks, bonds, etc. This feature presents investment flexibility not offered in 529 plans.

Fees and expenses

All 529 plans assess an overall management fee as well as the fees charged by the underlying mutual funds in 529 savings plans. The Coverdell is subjected only to the fees charged by the specific investment your client selects. Other set-up and maintenance fees may be applicable to both 529 plans and Coverdells.

Financial aid

The assets in a Coverdell are considered the property of the student when applying for financial aid and can significantly impact the student's ability to receive financial aid.

Similarly, assets in a 529 prepaid plan will impact the student's financial aid eligibility. At the present time, 529 savings accounts are considered the property of the account holder and are subject to more lenient tests for financial aid purposes.

Age limitations

Coverdells do not allow contributions after the beneficiary reaches age 18 and require that the funds in the account be spent on education expenses of the beneficiary by their 3oth birthday. (Age rules are not applicable for special-needs beneficiaries).

A 529 savings plan has no such provisions. A 529 prepaid plan typically requires that the funds be used within a certain period of time.

Transfers

Assets can be rolled over from one Coverdell to another; they also can be rolled from a Coverdell into a 529 plan. Assets cannot be rolled from a 529 plan to a Coverdell.

Gift limitations

An individual may make annual gifts up to $11,000 with no gift tax consequences. These rules apply to both 529 plans and Coverdells. However, 529 plans allow you to elect to treat contributions as occurring over a five-year period, thereby allowing a $55,000 contribution in one year.

Taxability

With some exceptions, 529 plans and Coverdells are subject to taxes and penalties for non-qualified withdrawals.

Strategies

For individuals not subject to income limitations who plan to send their children to private school, the Coverdell is an excellent tool in which to allocate your first $2,000 in education savings per year.

If funds are not used for private school, the Coverdell can be used to pay for college expenses or rolled over to a 529 plan. After contributing their first $2,000 to a Coverdell, they could then set aside funds into a 529 plan.

Sunset provisions

Unfortunately, most of the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 expire on Dec. 31, 2010. It is generally assumed that Congress will act to extend education tax incentives, but there is no guarantee.

Contact this Author: < Richard Nudelman > rnudelman@nudelmancpa.com

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