When it comes to saving for college, parents have a number of investment options to choose from. In addition to traditional savings accounts, you may choose to open a Coverdell Education Savings Account or a state-sponsored 529 plan. Each type of account has benefits and disadvantages. It's important to consider your student's anticipated need and your overall financial situation when choosing between these options for college savings.
Who Can Contribute
The Internal Revenue Service places an income restriction on who can contribute to a Coverdell ESA. As of 2010, the income limit for a single filer was $110,000. Joint filers are phased out at $220,000. You may open a Coverdell ESA for your minor child, grandchild or other relative. Anyone can contribute to a 529 plan, regardless of income. Every state offers at least one 529 plan, and you may contribute to any state's plan, regardless of residency. You can contribute to a 529 plan for any beneficiary of your choice, including your spouse or yourself.
Coverdell ESAs have a much lower maximum contribution limit than 529 plans. As of 2011, the maximum annual contribution limit is $2,000 per beneficiary. Since 529 contribution limits are regulated by each state, rather than the IRS, maximum contribution limits are much higher. Some states allow lifetime contribution limits of $300,000 or more. Contributions to a Coverdell ESA are not tax deductible. As of 2011, 34 states allow some type of tax deduction for residents who contribute to their state's 529 plan.
The IRS has specific guidelines regarding ESA and 529 plan withdrawals. As of 2011, these types of accounts may be used only for qualified higher education expenses at eligible institutions. According to IRS Publication 970, qualified expenses include tuition, books, fees, room and board and supplies. Students must be enrolled at least half-time to include room and board. Funds may be used at any college, university, vocational or technical school that is eligible to participate in federal student aid programs.
Coverdell ESAs have an advantage over 529 plans in terms of their investment options. You can generally choose from stocks, bonds, mutual funds, CDs or any combination with an ESA. With a 529 plan, your investment choices are typically limited to a narrow range of mutual funds. These types of funds are usually age-based or use a target asset allocation as their model.
Contributions to a Coverdell ESA are allowed only until the beneficiary reaches age 18. Funds in an ESA must be withdrawn before the beneficiary turns 30 to avoid having to pay regular income tax and a 10 percent penalty on the distribution. There is no age limit on contributions to or withdrawals from a 529 plan. You can roll over funds held in either account to another beneficiary with no tax penalty. If you withdraw funds from either type of account for any purpose other than higher education expenses, you will have to pay a 10 percent tax penalty.
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