It’s not uncommon for parents to place saving for future college expenses as a financial planning priority. A Coverdell Education Savings Account (ESA) or a state-sponsored 529 Plan could be an easy way to pay for today’s school expenses and put a little away for future college costs. Before opening an account, get the basics on these plans.
Coverdell Education Savings Account rules
The Coverdell ESA helps families save for future college tuition costs, but also to pay for today’s qualified K-12 school expenses such as tuition, uniforms or computers.
Any adult can open a Coverdell ESA in the name of a child with any financial institution. The IRS sets annual contribution limits to the account based on gross income requirements. Confirm contribution limits for single and joint tax filers with your financial advisor. With a Coverdell you can choose to invest in stocks, mutual funds and more.
How do 529 plans work?
Like many states, North Carolina has a 529 Plan. The NC 529® Plan, administered by the College Foundation of North Carolina, is a tax-advantaged, state-sponsored education savings plan. North Carolina’s plan offers investment options covering a range of risk strategies, from conservative to aggressive. A 529 Plan lets you choose how and when to invest funds, and when to use your funds, but only in education-related investment vehicles. You can be as hands-on or as hands-off as you choose with your investment approach.
These plans help your family save for future college or graduate school expenses like tuition, room and board, books and computers. Funds can also be spent on elementary and secondary school tuition or to repay student loans. The IRS has set plan contribution limits.
Coverdell versus 529 Plan
With both plans, earnings generally grow tax-free from federal and state income taxes when used for qualified expenses. The benefit of the 529 is the tax-free withdrawal of earnings built up in the plan over the years. So, if you get started early with 529 contributions, you may have built up significant earnings when it’s time to withdraw the funds.
Generally, all Coverdell contributions must be made before the beneficiary turns 18 and distributed before age 30. The one exception is if the child has special needs. Then, the account can continue to be funded and the money can stay in the account after age 30. Like 529’s, earnings grow tax-free and withdrawals are tax free when the funds are spent on qualified education expenses.
Contributions are not tax deductible for 529s nor are Coverdell accounts.
Unused education funds in 529 Plans can be transferred to another beneficiary with the same tax benefits. With a Coverdell ESA, usually by age 30 unused funds must be distributed to the original beneficiary. However, you may have the option to transfer the funds into a 529 Plan. In addition, any exemptions from taxes upon withdrawal no longer apply.
If you need to withdraw funds early from either of the accounts, you can, but you could be subject to tax penalties. Your tax advisor can help explain the implications.
Find your college savings strategy
If you’re planning to cover your child’s educational costs, use a college savings calculator to help you determine how much you may need to contribute.
The advice provided is for informational purposes only. Contact a financial advisor for additional guidance.