How Coverdell and 529 Education Savings Plans Differ

Article Highlights

  • Coverdell Education Savings Accounts

  • Qualified State Tuition Programs (Sec 529 plans)

  • Savings Contribution Limits

  • Gift Tax Issues

The tax code provides two primary advantageous ways of saving for your children’s education. We frequently get questions about the differences between the programs and about which program is best suited for a family’s particular needs.

The Coverdell Education Savings Account and the Qualified Tuition Plan (frequently referred to as a Sec 529 Plan) are similar; neither provides tax-deductible contributions, but both plans’ earnings are tax-free if used for allowable expenses, such as tuition. Therefore, with either plan, the greatest benefit is derived by making contributions to the plan as soon as possible—even the day after a child is born—to accumulate years of investment earnings and maximize the benefits. However, that is where the similarities end, and each plan has a different set of rules.

Coverdell Savings Accounts only allow a total annual maximum contribution of $2,000. The contributions can be made by anyone, including the beneficiary, so long as the contributor’s adjusted gross income is not high enough to phase out the allowable contribution. (The phase-out threshold is $190,000 for married contributors filing jointly and $95,000 for others.) Unless the beneficiary of the account is a special needs student, the funds must be withdrawn prior to age 30. The funds can be used for kindergarten through post-secondary education. Allowable expenses generally include tuition; room, board, and travel expenses required to attend school; books; and other supplies. Tutoring for special needs students is also allowed. Funds can be rolled over from one beneficiary to another in the same family. Although the funds can be used starting in kindergarten, the chances are that not enough of earnings will have been accumulated by that time to provide any significant tax benefit.

Section 529 Plans come in two types, allowing taxpayers to either save funds in a tax-free account to be used later for eligible education costs, or to prepay tuition for qualified universities. Typically, funds contributed to the college savings plan are invested in some sort of savings vehicle – generally mutual funds. Many of these plans offer stock funds when a child is quite young, which will then be transferred to more conservative investments (like bond funds) as the child gets closer to college age. As with any investment, there are no guarantees of growth and the plans are subject to the normal investment risks, even though state governments sponsor them. A big plus for these plans is they are not geared towards in-state schools or a specific institution but meant to be applied to whichever school a child chooses to attend.

Most state-run Sec 529 Plans, which were originally conceived to provide tax-advantages only when the funds were used for postsecondary education, now allow distribution of up to $10,000 per year per plan beneficiary to pay tuition (but not other expenses) for attendance at a public, private or religious elementary or secondary school.

These plans allow significantly larger amounts to be contributed than can be made to Coverdell Accounts; multiple people can each contribute up to the gift tax limit each year. This limit is $18,000 for 2024, and it is periodically adjusted for inflation. A special rule allows a contributor to make up to five years of contribution in advance (for a total of $90,000 in 2024).

Sec. 529 Plans allow taxpayers to put away larger amounts of money, limited only by the contributor’s gift tax concerns and the contribution limits of the intended plan. There are no limits on the number of contributors, and there are no income or age limitations. The maximum amount that can be contributed per beneficiary is based on the projected cost of college education and will vary between the states’ plans. Some states base their maximum on an in-state four-year education, but others use the cost of the most expensive schools in the U.S., including graduate studies. Most have limits more than $200,000, with some topping $475,000. Generally, once an account reaches that level, additional contributions cannot be made, but that doesn’t prevent the account from continuing to grow.

Generally, the same type of expenses listed above for Coverdell Accounts are eligible expenses for Sec 529 Plan distributions. However, in recent years, Congress passed laws expanding the type of educational expenses eligible for tax-free distribution from 529 Plans, including repayment of student loans (maximum lifetime limit of $10,000) and apprenticeship expenses.

Taxpayers are permitted to claim an American Opportunity or Lifetime Learning credit for college tuition and expenses and exclude amounts distributed from a Sec 529 Plan during the same tax year for the same student, but not with respect to the same expenses.

Which plan (or combination of plans) is best for your family depends on several issues, including education goals, the number and ages of your children, the finances of your family and of any grandparents or other relatives willing to help, and others. For assistance in determining the right education savings plan for your family, please give the office a call.

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