You’ve looked ahead past that cute gap-toothed smile or those first stressful days of middle or high school and realized “it’s time.” Saving now for college will give your child the best possible future and provide him with many options for schooling in the future.
Deciding to save for college is just the beginning, though. You also need to determine which savings and investment plan will allow you to accumulate the most money and most effectively cover your child’s needs and costs. You have several options, but a plan specifically designed just for college savings is usually the best bet, as it will have built-in tax breaks for education.
Two of the most popular ways to save for college are the Coverdell plan and the 529 College Savings Plan. While both will help you save for your child’s coming education, they offer different benefits and one may suit your needs far better than the other. Getting the facts about Coverdell and 529 College Savings Plans and make an informed decision for your family.
Since both the 529 and the Coverdell plans are designed for education, and both offer tax savings, why does it matter which one you choose? The differences between the two have a significant impact on how much you can save and where you can spend the money, so learning how they differ is key to choosing the right plan for you.
The 529 Plan
A 529 plan is designed specifically for college savings. In many ways, it functions as a retirement account, offering tax-free growth and tax-free withdrawals when it is time to pay for your child’s education. If the money you are withdrawing is for educational expenses, there are no unexpected fees or penalties to deal with. For most families, this is the most flexible and affordable vehicle for their savings.
Like the 529 plan, a Coverdell is designed for education expenses and offers tax advantages. The amount you can save each year is limited though, and this plan may not be flexible enough to meet your needs. In specific circumstances, though, a Coverdell is an excellent savings tool; learning about this savings vehicle ensures you cover all your bases as you research your college saving options.
How Much Will You Contribute?
The annual contribution limits are different for the Coverdell and the 529 plan. The Coverdell has an annual cap on contributions; you can only invest $2,000 a year in your plan. That may seem like a lot now, but if your income goes up over time and as college draws near, you’ll reach that limit very quickly.
A 529 plan has contribution limits as well, but they are far higher. Gifts of $15,000 per year are allowed for tax years 202 and 2021, though amounts over that limit could be subject to a gift tax. There is also a limit to the overall value of the plan, but this usually is over $300,000, depending on the specific 529 plan.
Where Will You Spend the Money?
Your 529 plan savings can be used at colleges and universities for qualifying education expenses, which include tuition and other related costs, from rent (in many cases) to required books and supplies.
A Coverdell plan can be used for K-12 or higher education. If your child attends a private elementary, middle, or high school, then this plan has some advantages for you while they are in the pre-college years.
A 529 plan can be used for your first child—and then for the next in line as they head to college. This flexibility prevents you from saving “too much” or not being able to use all your savings. Since you, the parent, own the plan, there are no age limitations.
For a Coverdell, all saving for a specific child needs to be done by that child’s 18th birthday, even if they are still in high school at the time. There are also strict (and ever-changing) income guidelines to qualify to save using this vehicle.
Can Others Contribute?
Your friends and family want to see your child succeed, and some are just plain tired of buying plastic toys that kids will outgrow or that will become obsolete in just a few short months. Using a service like CollegeBacker gives these important people a chance to contribute in a meaningful way each birthday or holiday.
The 529 plan supports and even encourages gifts from friends and family; gifts under $15,000 are exempt from the gift tax for 2020 and 2021, so your savings can grow even more quickly. The Coverdell limitations do not make it suitable for getting others involved, so you can’t easily accept gifts or allow others to contribute to your child’s education.
Tax Advantages and Considerations
Both the 529 plan and the Coverdell offer tax advantages for your savings; those savings are similar and based on your overall financial outlook. The more significant differences between the two plans are more important to the decision-making process than taxes. Note that some states have additional tax deductions or credits for college savings plans.
Withdrawals and Penalties
Your 529 plan principal can always be withdrawn without penalty, and the interest earned can be used penalty-free, provided you are spending the money on qualified education savings. If you withdraw for non-qualified expenses, there is a 10 percent penalty on the growth. You can get around this by withdrawing strategically, but it is important to know before you decide.
You can withdraw your Coverdell funds for schooling—either college or private school—without penalty. It needs to be used for the child designated as the beneficiary, though, and must meet the qualifying expenses guidelines.
Fees and Costs of Using Each Plan
Both 529 plans and Coverdell plans have fees; these fees will vary depending on the actual plan you choose. See the fees for any specific plan you are considering before you decide.
The Bottom Line
While both 529 plans and Coverdell plans have the same goal in mind—saving for education—the limitations on contributions for the Coverdell makes it an unappealing option for many families. Choose the Coverdell if you need to save for private school or in some specific situations, but the 529 is far more flexible and allows for gift-giving, making it an ideal option for most families.