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Saving for College – 529 Plans & Coverdell ESAs

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Carnegie Mellon FlagI was watching On The Money last week when host Carmen Ulrich touched on saving for college education. She stated that college education costs go up around 8% a year, a figure that was much higher than what I had seen quoted before. She didn’t cite her source but I imagine it was probably FinAid.org, a well-known site that helps families plan for financing education costs, because they state college costs go up between 5% and 8% each year. That outpaces inflation and obliterates prevailing savings account rates… scary thought.

My wife and I are thinking about having kids soon and one of the biggest challenges has been projecting and planning for the cost of college. It’s pretty sobering to use FinAid’s projection calculator. I put in $30,000 a year (just a ballpark figure for a year of private college today), 20 years until matriculation, and left the college cost inflation rate at 7%. The total four year cost? $515,435.35

Half a million bucks for a private college. It’s insane.

Fortunately there’s help available and it comes in multiple forms:

  • Saving for college before college starts: This is the topic of this article, learning more about the ways you can save money by taking advantage tax-advantaged education savings accounts like 529 Plans and Coverdell ESA’s.
  • Tax deductions and credits for when your child is attending college: I won’t be going into detail about these deductions and credits in this article but you can get some assistance through the Hope and Lifetime Learning Credits. They may not exist in 20 years but they’re available today.
  • Financial aid: Also not covered in this article, but financial aid, whether it’s need or merit-based, plays a huge role in helping families pay for college and should always be considered.

Here’s a brief overview of your options (for saving for college) to give you a sense of what your options are. This is by no means exhaustive but should give you a good idea of the landscape so you can do your own investigating.

529 Plans

Named after the section number in the IRS code, the 529 Plan is simply a savings plan for college education and has two options:

  1. Prepay tuition at a qualified institution at today’s tuition rates, or,
  2. Save money in a account where the earnings are tax-deferred to pay tuition at future rates.

All earnings in the account are exempt from federal taxes if withdrawn and used for qualified educational expenses. Your contributions, however, are taxed before you put them in but some states let you deduct a portion of them from your state taxes. The Pension Protection Act of 2006 made the tax exemption permanent.

Coverdell Education Savings Accounts (ESA)

The Coverdell ESA was once known as the Education IRA and was revamped in 2002 with some major changes. Again, the account is like a Roth IRA in that you make non-deductible contributions into an account that can grow tax free if used for education. Like the Roth IRA, your contribution limit is affected by your adjusted gross income. For single filers, the range is $95k – $110k, and for married filing joint, it’s $190k – $220k; the contribution limit for 2008 is $2,000 per beneficiary.

Unless Congress makes changes to the existing law, some ESA benefits will expire in 2010. The key ones are that K – 12 expenses won’t qualify, the contribution limit will lower to $500, and withdrawals won’t be tax free if you claim Hope or Lifetime Learning credits. I don’t know if they acted yet on this and I couldn’t find anymore information about this.

Treasury Bonds

Earlier this year I bought some Series I bonds because of the favorable interest rates. One of the benefits of Series I bonds, and Series EE bonds, is that earnings are tax free if used for education. The rules are that “qualified higher education expenses must be incurred during the same tax year in which the bonds are redeemed.” There are several other requirements but they are all spelled out in the education planning section of Treasury Direct.

The benefit here is that you can get a lower guaranteed return, unlike the stock market investment returns for Coverdell and 529s, on education savings but the rules are slightly stricter. Also, you are limited in how much you are allowed to purchase.

Difference Between 529s & ESAs

There are some major differences, and lots of minor differences, between these plans.

The first has to do with control of the account. With a 529, the owner always retains control and can change beneficiaries at will. With ESAs, the money gets transferred to the benficiary (your child) if it’s not used for education when they reach a certain date. With 529s, the money is returned.

Another difference has to do with contributions, the limit for Coverdell is $2,000 a year subject to the contributors’ modified income. With 529′s, the limit is usually several hundred thousand and depends on the state program you join.

The last major difference is that a Coverdell has to be used up or transferred by the time the beneficiary turns 30, or the funds have to be withdrawn and tax and penalties must be paid. With the 529, there is no age limit. This is significant because that means you can open a 529 for your child before they are born. You simply open one for yourself, contribution, then change the beneficiary when the child is born. You can’t do this with a Coverdell.

As for similarities that may affect your choice, the Coverdell and the 529 are the same for financial aid purposes. They are considered assets of the custodian, which would be you, and the withdrawals are not income when they are tax free. Both plans are transferable, meaning you can change the beneficiary fairly easily.

Have you taken a deeper look at these types of plans? If so, what made you choose one or the other? Are there major differences, advantages, or disadvantages that I overlooked?

(Photo: duruk)

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5 Responses to “Saving for College – 529 Plans & Coverdell ESAs”

  1. I agree that college costs are getting scary high. That said, I don’t think it is correct to look at the $30,000 price tag and map out a 20 year return of 7%. $515,000 in today’s dollars looks like a lot more than $515,000 will 20 years from now. If you figure inflation is 3% per year your actual annual cost increase is only 4%. After 20 years, using FinAid’s calculator you will wind up with $279,000 – adjusted for inflation. That number is still a hefty chunk of change that you will need to save up. But, it doesn’t pack quite the psychological blow that $515,000 does.

  2. No big. From my point of view $279K might as well be $515K. : )

    Thanks for the info on Coverdell. I had a pretty solid understanding of 529 plans but wasn’t as familiar with Coverdells. You don’t hear much about them now-a-days.

  3. Bob says:

    Before a 529 plan a parent should consider the Monetta Young Investor Fund(MYIFX). You can use either a Coverdell or UGMA account. This is one of the few funds that actually gets kids involved in the savings process with a financial literacy component and offers college tuition credits that can offset up to one-year tuition cost at over 220 colleges. The minimum investment is $100 with a $25 monthly AIP.

  4. Dave says:

    After just finishing helping to put my daughter through college, I’ll make a couple of observations:
    1. It’s darn near impossible to try and save for every college expense. In those 18 years between birth and freshman year, life happens. You buy a house, you change jobs, the car breaks down, you buy a new car, etc. We set some money aside years ago in I bonds (enough to pay a couple years of tuition) but I decided to just pay tuition out of current income because it would just pain me to cash out something that is getting a safe 8.5% return.
    2. Hopefully, your child will be industrious. My daughter always worked part time (full time over summer breaks), applied for scholarships ($100 here, $500 there) and pretty much supported herself all four years at college. I paid her tuition (as I promised to do when she was in high school) but I told her early and often she’d have to provide for her other expenses. And she did! And I’m very proud of her and tell her that often. She also loves her independence saying it is a very freeing thought to be able to come and go from her own apartment whenever she wants without having to “check in.” LOL!


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