Put on your thinking cap when weighing educational savings plans
As we approach Christmas and the thought of the perfect gift, I remember a high school teacher who always talked about the “gift of education.” This seems like the perfect time to talk about Coverdell Education Savings Accounts and 529 Education savings plans.
The Taxpayer Relief Act of 1997 created a tax-favored education individual retirement account designed to help certain taxpayers save for a child’s education. These plans have been renamed as Coverdell Education Savings Accounts. Money contributed to a Coverdell ESA is nondeductible, but earnings accumulate tax-deferred.
Contributions to a Coverdell ESA are treated as nontaxable gifts to the beneficiary. In general, to the extent that earnings are distributed to pay qualified educational expenses, the earnings are excluded from the beneficiary’s income and are received free of federal income tax.
The contributor need not be related to the beneficiary and there is no limit on the number of individual beneficiaries for whom one contributor may set up a Coverdell ESA.
Federal income tax law currently limits contributions to a Coverdell ESA to $2,000 per beneficiary per year. Contributions must be in cash and must generally be made before the beneficiary reaches age 18.
Coverdell ESAs provide a tax-favored framework within which funds may be accumulated to pay for a beneficiary’s “qualified education expenses.” Depending on the educational level involved, the definition of qualified education expenses will change, as will the allowable educational institutions.
A “529” education savings plan is a tax-favored program operated by a state and designed to help families save for future education costs. While the fees, expenses and features of these plans vary from state to state, as long as a plan satisfies the requirements of Section 529 of the Internal Revenue Code, federal tax law provides tax benefits for the contributor and the beneficiary.
The major difference between a Coverdell ESA and a 529 plan is the contribution limits. The Coverdell limit is $2,000 per beneficiary and does not allow multiple accounts for the same beneficiary. Federal law allows single taxpayers to contribute to $14,000 in one year, or make a lump-sum contribution of $70,000 to cover five years.
Coverdell ESAs can allow almost any investment inside, including stocks, bonds and mutual funds, while 529 plans only allow a choice among a number of state-run allocation programs.
Balances in a Coverdell must be disbursed on qualified education expenses by the time the beneficiary is 30 years old, or given to another family member below age 30 in order to avoid taxes and penalties; there is no limit for 529 plans.
There are important similarities of both plans. When the student is a dependent and not an owner of the account, money in both plans is not considered the child’s money when applying for federal financial aid. The custodian of both an ESA and a 529 plan can designate a new beneficiary without incurring taxes or penalties, provided that the new beneficiary is an eligible family member of the previous beneficiary (child, niece, nephew, grandchildren).
As always, before purchasing, talk to your tax adviser and your financial adviser to get complete details of the benefits and rules of these two educational savings plans.
Have a safe and happy holiday season!
Bob Hollick is a State Farm Insurance agent based in Washington.
To submit columns on financial planning, investing or business-related matters, email Rick Shrum at rshrum@observer-reporter.com.