Back to School

It's hard to believe August is here already, and that puts many families in back to school mode.  So I thought I'd review college saving plans - the Coverdell vs the 529 plan. Today, some parents are wondering if they should convert Coverdell Education Savings Accounts to 529 college savings plans. With that mind, here is a brief look at how both of these accounts work.

Why have Coverdell ESAs been so popular? Imagine a Roth IRA used only for college savings. That's basically the concept behind a Coverdell. In fact, the Coverdell ESA evolved from the Education IRA.¹¹  

Contributions to a Coverdell ESA aren’t deductible, but you get tax-deferred growth. Contributions must be made in cash. Withdrawals from Coverdells are (currently) tax-free if used for qualified educational expenses such as tuition, fees and books. The funds can also pay for certain K-12 education costs.^1,2

You can allocate Coverdell account assets among many different kinds of investment vehicles, and many banks, credit unions and mutual fund providers offer these accounts. However, Coverdells have some drawbacks. The annual contribution limit to a Coverdell is $2,000, and an individual taxpayer with modified adjusted gross income above $110,000 cannot contribute to a Coverdell (the MAGI limit is $220,000 for joint filers, with phase-outs kicking in at $190,000).^2,3

Aside from a limit on annual contributions, there are also some age requirements. The Coverdell ESA beneficiary must be younger than 18 when the account is set up and the money in the account must be spent or transferred before the beneficiary turns 30. At that point, the funds will have to be withdrawn and taxes and a 10% penalty may be assessed on the withdrawal. (If a beneficiary has special needs, contributions after age 18 and retention of the account assets after age 30 may be allowed; see IRS Publication 970 for details.)^1,2

Big changes are scheduled for Coverdells in 2013. Unless Congress intervenes, these accounts will be a lot less attractive next year. Beginning in 2013:

• The annual contribution limit will drop from $2,000 down to $500.
• Distributions will be tax-free only if you don’t claim a Hope or Lifetime Learning Credit in the same tax year.
• No withdrawals may be used to pay for K-12 education expenses.⁴

All this has many parents thinking about shifting their Coverdell funds to a 529 plan.

Thinking of moving Coverdell assets into a 529? You can do a rollover from a Coverdell ESA to a 529 plan without incurring any tax penalties as long as the 529 plan will have the same beneficiary as the present Coverdell account.⁵

Earnings from a 529 plan can be distributed tax-free (assuming they are used for qualified education expenses). Contributions are taxed.⁶

You can go one of two ways with a 529:

• You can prepay tuition at today’s rates (at a qualifying college or university) through a 529 prepaid tuition program.
• You can save to pay tomorrow’s college tuition through a 529 savings plan which gives you tax-deferred growth. Most people prefer this option for its flexibility and asset accumulation potential.⁷

You can put much more money into a 529 annually than a Coverdell. Many 529 plans allow annual contributions of more than $200,000. Some do have “lifetime” limits on total contributions. Regular contributions must be in cash.^8,9

A 529 plan has no phase-outs. You will never be too rich to put money into a 529 plan. There are no income restrictions affecting plan contributions.⁶

Need to remove some money from your taxable estate? A 529 plan gives you an option to do just that. In 2012, a contribution of $13,000 a year or less to a 529 plan qualifies for the annual federal gift tax exclusion. So you and your spouse can take advantage of this, andso can your relatives. So can anyone. In fact, any taxpayer can contribute up to five times the annual gift tax exclusion to a 529 plan (in 2012, $13,000 x 5 = $65,000) without incurring gift taxes or eating into the unified credit, as long as that taxpayer refrains from making other cash gifts to the 529 plan’s designated beneficiary for the next five years. (For married couples filing jointly, this limit is $65,000 x 2 = $130,000.) This $65,000 will only be included in the donor’s taxable estate if the donor dies within the aforementioned five-year period.^6,8

Other nice features. As the owner of a 529 plan, you retain control of the assets and have the power to change the designated beneficiary (each 529 plan may only have one). You can even start multiple 529 plans in different states.^6,8,10

You may wish to move assets from a Coverdell ESA to a 529 plan. You certainly will want to keep up with developments affecting these accounts and other education savings options. Your financial consultant can help you stay informed.

Kim Bolker may be reached at kbolker@sigmarep.com or 616-942-8600.  This material was prepared by MarketingLibrary.Net Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. Marketing Library.Net Inc. is not affiliated with any broker or brokerage firm that may be providing this information to you. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is not a solicitation or a recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.

1 – irs.gov/newsroom/article/0,,id=107636,00.html [10/5/11]

2 – irs.gov/pub/irs-pdf/p970.pdf [2/14/12]

3 – personal.vanguard.com/us/insights/article/coverdell-esa-extend-03012011 [3/1/11]

4 – edwardjones.com/en_US/products/education_saving/coverdell/index.html [6/28/11]

5 – law.cornell.edu/uscode/search/display.html?terms=529&url=/uscode/html/uscode26/usc_sec_26_00000530----000-.html [2/16/12]

6 – www.irs.gov/newsroom/article/0,,id=213043,00.html [6/15/11]

7 – smartmoney.com/spending/deals/the-529-basics-10676/ [2/3/10]

8 – learn.bankofamerica.com/articles/money-management/529-college-savings-plans-explained.html [6/28/11]

9 – investopedia.com/university/retirementplans/529plan/529plan1.asp [9/28/10]

10 – schwab.com/public/schwab/planning/college_planning/529_plan/faqs [9/7/10]

11 – www.fool.com/money/allaboutiras/allaboutirasglossary.htm   [2/16/12]