Tax Article - Comparing Coverdell ESAS With 529 Plans

Floyd, an investment analyst, and Marietta, an educational researcher, are a married couple with a five-year-old son and a newborn daughter. Like many parents, they’d heard and read plenty about 529 plans, but they wanted to know whether there were any other college funding alternatives worth considering. They visited their financial advisor to learn more.

Their advisor pointed out that perhaps the most widely discussed alternative is the Coverdell Education Savings Account (ESA). Like 529 plans, ESAs can be used to amass funds for education expenses tax free. And Floyd and Marietta could make contributions to either plan — or both — on behalf of each of their children each year.

Moreover, under both plans, distributions are tax free for federal purposes if used to pay qualified education expenses at any accredited college or university, including most community colleges and technical training schools. The two plans, however, have some key differences.

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Contributions and deductions

The primary difference between ESAs and 529s relates to contributions. Whereas there is no federally mandated ceiling on contributions to a 529 plan, the maximum annual contribution to an ESA is $2,000 per account beneficiary.

In addition, as joint filers, Floyd and Marietta’s ability to contribute to an ESA would be limited if their adjusted gross income fell between $190,000 and $220,000, and eliminated if it exceeded that range. (This phaseout range is $95,000 to $110,000 for single filers.)

Plus, contributions aren’t allowed after the beneficiary reaches age 18 (unless the beneficiary is a special needs beneficiary). Unlike other tax rules that look at a child’s age as of year end, the ESA contribution rules look at the age as of the time of contribution.

So, if Floyd and Marietta wish to make a contribution for the year their child turns 18, they must be sure to do so before the child’s birthday. Thus, if their son (who doesn’t have any special needs) turns 18 on May 1, contributions for him must be made no later than April 30. (And they could continue contributing on behalf of their daughter.)

For federal tax purposes, neither 529 nor ESA contributions are deductible. Some states, however, allow state income tax deductions or credits for 529 plan contributions, at least if the plan is sponsored by that state.

Matters of control

Perhaps the primary advantage ESAs have over 529s relates to matters of control. Unlike many (if not most) 529 plans, which would require Floyd and Marietta to invest in a managed portfolio based on the age of the beneficiary in question, they could choose the investments to hold in their ESA. As an investment analyst, Floyd is particularly drawn to this factor.

Additionally, the couple would have more control over where their ESA funds could go. ESA distributions are permitted for elementary and secondary education costs (including academic tutoring) as well as for college funding. So if they decided to send their daughter to a private grade school, they could use an ESA to pay for it.

A question of circumstances

The limitless contributions allowed for 529 plans are highly appealing to a wide range of people. But, under the right circumstances, an ESA can serve as a useful alternative or supplement. Floyd and Marietta were glad they asked about it.

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