Tax Differences College Palsn: 529 Plan vs. Coverdell ESA

Millions of students are heading off to college and that collective groan you hear is the sound of parents who are scrambling to figure out how to handle the cost. While scholarships and grants can ease some of the burden, the demand often outstrips the supply of funding. Loans are another alternative but as the current student liability crisis has demonstrated, borrowing isn’t always the wisest move.

One of the best ways to tackle the question of how to pay for education expenses is to start saving as early as possible. Parents have plenty of options, but two of the most popular ones are 529 plans and Coverdell Education Savings Accounts. Both offer certain tax advantages but there are some key differences you’ll want to consider before you decide on a plan. If you’re ready to start beefing up your child’s college fund, here’s a look at how they measure up.

How 529 Plans Work

A 529 plan, also known as a qualified tuition program, can take one of two forms: college savings account or a prepaid tuition plan. Every state offers at least one type of 529 plan and you don’t have to live in a particular state to participate in their plan. The savings plan allows you to set aside money on a regular basis that can be used for future education expenses. Prepaid tuition plans let you purchase college credits at a locked-in rate. The lifetime contribution limits for either type of plan vary by state, but you may be able to sock away as much as $300,000 per student.

Coverdell Account Basics

A Coverdell Education Savings Account or ESA is also designed to help parents save for education expenses but there are some specific rules that govern who can contribute and how much you can put in. As of 2014, the annual contribution limit is capped at $2,000 per student and your modified adjusted gross income must be less than $110,000 for single filers or $220,000 if you file jointly. The other key difference between a Coverdell account and a 529 plan is that you can only make contributions until the account beneficiary turns 18.

Taxes on Withdrawals

Any money you put into either type of account is not tax-deductible at the federal level, although some states allow a deduction for 529 contributions. Generally, your withdrawals from a 529 or Coverdell account are tax-free as long as the money is used to pay for qualified higher education expenses at an eligible institution. This simply means any college, university, trade or vocational school that’s eligible to participate in federal student aid programs.

Qualified expenses include things like tuition, fees, books, supplies, equipment, additional costs required for a special needs student and room and board. Students have to be enrolled on at least a half-time basis. If you take money out of either plan in excess of the amount that’s necessary to cover qualifying education costs, you’ll have to pay income tax on the earnings part of the distribution, along with a 10% withdrawal penalty.

Gift Tax and Penalties

One of the things parents need to be aware of with regard to 529 plans is the potential for incurring gift tax, which is assessed when you give money to someone else. As of 2014, you could exclude cash gifts of up to $14,000 or $28,000 for parents who are married and file their taxes jointly. Alternately, you can elect for the five-year option, which allows you to contribute up to $70,000 or $140,000 for joint filers at a single go. The catch is that in order to avoid the gift tax, you can’t make any additional gifts until the five-year period ends.

Since the contribution limits for a Coverdell ESA are so much lower, you may not have to worry about the gift tax if it’s your only savings vehicle; however, there are other tax implications you need to be aware of. Any money remaining in a Coverdell account must be distributed when the beneficiary reaches age 30, unless they meet the special needs exception. If you don’t take the money out before then, it’ll be treated as income and is also subject to the additional 10% penalty.

The sooner you get started with college planning, the better off you’ll be when it’s time to send your kids to school. Weighing the pros and cons of both types of accounts can help you decide which one is best from both a savings and tax perspective.