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Paying For College Costs: The Coverdell Education Savings Account vs. The 529 Savings Plan

TROY, Michigan – July 23, 2004 – To most parents, saving for their children’s higher education costs can seem like a daunting task, which makes planning all the more critical.

This year the College Board (www.collegeboard.com) released a report which stated that most students and their families can expect to pay, on average, from $231 to $1,114 more for the 2004-05 college school year than they did in 2003-04 for tuition and fees. A 2004 CNN Money report (http://money.cnn.com/sales/aessuccess/articles/manage_rising_costs/) stated that the cost of an average college education is rising at a level two to three times the rate of inflation. In addition the average cost of a four-year private college is more than $80,000 and more than $40,000 at four-year public institutions.

The good news is that there is more financial aid available than ever before -- over $105 billion for the 2003-04 school year, according to the College Board. Tax-deferred savings plans have made it much more advantageous for parents to plan ahead and develop an affordable strategy for sending their kids to college. 

The challenge is determining which savings plan is the best for your situation and gaining a thorough understanding of the different options available without going crazy.

Two Available Options

The Coverdell Savings Account (ESA) works much like a Roth IRA. Users can contribute up to $2,000 annually into a beneficiary’s Coverdell account.  Earnings on contributions will be distributed tax free, as long as they are used to pay the beneficiary’s elementary, secondary, or college education expenses. 

In contrast, a 529 Savings Plan is an educational plan operated by a state or educational institution that is intended to help parents save for their children’s college costs. The money contributed grows tax deferred, and starting in 2004, distributions used to pay for the beneficiary’s college costs are tax free at the federal level.  In many states, individuals who contribute to a 529 plan also receive a state tax deduction.

Key Differences Between Plans:

Qualifying Expenses:

Generally, distributions from both of these plans are federally tax-free if they are used to pay for the beneficiary’s qualified educational expenses.  The difference between these two plans lies in what is considered a “qualified expense”. 

A Coverdell ESA defines “qualified expenses” as tuition, room, board, fees, supplies and special needs related to the attendance of a qualified elementary, secondary or post-secondary institution.  In contrast, a 529 plan more narrowly defines “qualified expenses” as tuition, room and board, fees and supplies required for attendance at an institution of higher education. 

Perhaps the difference between “qualified expenses” does not matter much to an investor who is saving specifically for higher education costs.  However, this can be a drawback for those looking to save their child’s kindergarten through grade twelve education. 

Qualifying Contributions and Contribution limits:

The maximum contribution that can be made to beneficiaries Coverdell ESA is limited to $2,000 annually.  Furthermore, the beneficiary of the plan must be under the age of 18.  The maximum contribution per beneficiary becomes limited when the donor’s adjusted gross income rises to between $95,000 and $110,000 ($190,000 and $220,000 if filing jointly). 

In contrast, there is no income limitations or age restrictions to those wishing to contribute to a 529 plan.  The maximum contribution to the plan is only limited to what is considered necessary to provide for the qualified expenses of a beneficiary (This can vary by plans.  The Michigan Educational Savings Program (MESP) for example, limits the overall account balance to $235,000 for all accounts opened for a beneficiary.).  Consequently, a gift tax return must be prepared for a single parent who contributes to the plan in excess of $11,000 per beneficiary in one tax year.  With a married couple, the annual gift tax exclusion increases to $22,000.

Control of the Account:

In a Coverdell ESA, the beneficiaries obtains control of the funds upon reaching the age of 18 in most states, and by the age of 30 funds are required to be distributed.  In contrast, a 529 allows greater flexibility by allowing the account owner control of the funds. 

This offers a degree of insurance to parents who believe that their child could use the money unwisely upon reaching the age of 18.  On the upside, both of these accounts offer the option of shifting the funds to an alternative beneficiary.

Reports of rising college costs can be intimidating.  However, by sacrificing a relatively small amount of income each month to an investment/savings account throughout a child’s lifetime, parents will find these costs to far less burdensome.  The sacrifice is well worth it.  

According to the U.S. Census Bureau statistics, people with a bachelor’s degree earn over 60% more on average than those with only a high school diploma.  Over a lifetime, the gap in earnings between those with a high school diploma and those with a B.A. or higher exceeds $1,000,000.

In the long run, the cost of not obtaining a college education (through lost earnings) is greater than the cost (tuition and other costs plus lost wages) of obtaining one.  Provided plans are made in advance to fund this cost, it becomes a much more easily managed financial undertaking for parents of any income level.