Tax Treatment

As with ESA’s, contributions to a 529 Plan are not deductible for federal tax purposes. However, earnings are tax-deferred. And if used for qualified education expenses, accumulated funds can be withdrawn tax free.

One feature that some 529 Plans have which all ESA’s don’t are state tax benefits. Some state plans offer an upfront deduction on contributions, while others make withdrawals exempt from state taxes in addition to the federal tax exemption.

Contribution Limits And Requirements

Each state has their own 529 Plan, but investment in a state’s plan doesn’t restrict you to using the funds for a school in that state. You can live in Texas, invest in a California plan, and send your beneficiary to college in New York.

With the inflation rate for college rising faster than the normal inflation rate, some people want to save more than the $2,000 annual limit for ESA’s. The 529 Plan has a much larger limit. You can contribute up to the limit set by the state offering the plan, which is usually over $300,000 per beneficiary.

And unlike ESA’s, there are no income limitations for those who want to contribute to a 529 Plan.

Qualified Withdrawals

Unlike ESA’s, in which beneficiaries must use the assets by the time they reach age 30, there is no age limit on the use of 529 Plan assets.

But although ESA funds can be used for elementary, secondary, and post secondary school expenses, funds in a 529 Plan can only be used at a post secondary school.

And like the ESA, earnings in a 529 Plan that aren’t used for qualified expenses will be subject to income tax and a 10% penalty.

Available Investments

While ESA’s are more flexible with the type of investments you can choose, 529 Plans are more restrictive. Funds can only be invested in portfolios established by the plan.

Each portfolio will have different investment objectives, but there will usually be an option for a portfolio whose asset allocation becomes more conservative as the beneficiary reaches college age. In addition to this, you’re allowed to change the investment strategy once a year.

Additional Benefits

Not only is the 529 Plan a great savings tool for college – another benefit is that it can be used to reduce the size of your estate. Contributions of up to $13,000 per year can be made to the 529 Plan without paying a gift tax. Once completed, this money is removed from your estate.

And since you can treat a contribution as being made over a five-year period for gift tax purposes, you can contribute a lump sum of $65,000 in the first year and still avoid gift tax. With this method, the money and its future appreciation will be removed from your estate faster.

Closing Thoughts

So because of the larger contribution limits, state tax benefits, and ability to remove assets from your estate, I think the 529 Plan has the advantage over the Coverdell ESA.

What do you think? Do you have a 529 Plan? Do you like them better than Coverdell ESA’s?

This post was included in the Carnival of Personal Finance during the week of July 6, 2010. Check out My Journey To Millions’ for a variety of great articles!

What It Is

A Coverdell ESA is an investment account in which the funds can be withdrawn tax free if used for qualified education expenses.

Contributions are not deductible, but earnings are tax deferred. The account can be funded until the beneficiary reaches age 18. However, if the funds are not used by the time the beneficiary reaches age 30, both income tax and a 10% penalty will be owed on the earnings.

Who Can Open One?

As long as your modified AGI is under $190,000 ($95,000 for single filers), you can make the maximum contribution, which is $2,000 per year. But if you AGI is between $190,000 and $220,000 ($95,000 and $110,000 for single filers), your maximum contribution is gradually phased out.

Although the beneficiary must be under the age of 18 at the time of contribution, he or she does not need to be your child or relative. So you can open an account for the child of a good friend if you wanted to.

Multiple accounts can even be opened for a child by several contributors, as long as the total contributions from all individuals is within the $2,000 annual limit. Otherwise, a 6% penalty is owed on the excess.

What If You Make Too Much Money?

A nice benefit of the ESA is that if your income is over limit, an account can still be opened for the child. By gifting the money to the child, he or she can open the account and make the contribution. There’s no need for the contributor to have earned income.

What Can You Invest In?

Your contribution can be invested in stocks, bonds, mutual funds, and CD’s. However, life insurance isn’t allowed.

What Can You Use The Money For?

Not only can the funds be used at a post secondary institution, but they can also be used for both elementary and secondary school expenses. Qualified expenses include tuition, fees, room and board, books, supplies and equipment required for attendance.

Tips And Tricks

Since you’re making a big investment in the education of another person, you may be worried if the beneficiary decides not to go to college. Luckily, you can transfer the funds to another beneficiary, as long as they are a member of the family under age 30. Some of the qualifying members include the beneficiary’s children, siblings, parents, first cousins, and in-laws.

One last important note is that certain ESA benefits are set to expire after 2010. Unless Congress acts, elementary and secondary school expenses will no longer be considered qualified expenses, and the contribution limit will be reduced to $500 per year.

For more information, check out savingforcollege.com.

Do you have a Coverdell ESA? What do you like about it? What do you not like about it?

This post was included in the Carnival of Personal Finance during the week of June 28, 2010. Check out Suburban Dollar‘s blog for a variety of great articles!

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