In my previous post, I analyzed the benefits of a Coverdell Education Savings Account and found out that it is a very powerful vehicle, despite its low $2,000 annual contribution limit. It can be used not only for elementary, middle or higher education, but for homeschooling as well, which makes it unique. In addition, the Coverdell ESA gives more flexibility in terms of investment choices, allowing you to invest almost in all stocks, bonds, and funds out there on the market.
However, there is a catch. As I mentioned before, one of the drawbacks of the Coverdell is a very low annual contribution limit, just $2,000 per year per beneficiary. Besides that, there are limitations on contributor’s annual income and at some point you may even not be allowed to make contributions at all.
But what if your income is above Coverdell’s limits and you want to save for your children’s education? Are there any other education savings vehicles worth paying attention to? Of course, there are!
What is a 529 plan?
Today, I would like to talk about a 529 plan, another education savings vehicle created In 1996. A 529 plan, in contrast to the Coverdell ESA, can only be used to pay for qualified college education expenses only. The plan is administered by a specific state, but that does not mean you are restricted to the state you live in. You are willing to choose a 529 plan from any state, depending on its benefits and investment options. For instance, if you are a resident of Illinois, you can easily investment in a California’s 529 plan and send your kid to any Massachusetts college.
There are two types of 529 plans: prepaid tuition plan and savings plan. The former one allows you to buy all or part of the specific state college tuition based on today’s prices and hence, freeze the cost of college. The latter one assumes investing contributions in different investment vehicles (usually mutual funds) where account growth depends solely on the market performance of the underlying instruments. Obviously, there is no lock in tuition costs with savings plan and you may end up either overfunded or underfunded, depending, again, on the market performance.
Let’s look at some other important features of a 529 plan
- Money in the plan grows tax-free. However, contributions are not tax deductible
- Some states may provide additional tax credits and deductions by investing in primary residence state 529 plans
- No maximum age limit. If your child decides not to go to a college, money can remain in the plan for as long as needed. Alternatively, funds can be rolled over to another immediate family member and used to pay for his/her college education expenses
- Qualified withdrawals like tuition, books, room, and equipment are tax-free from federal income tax. Many states also offer tax-free withdrawals for residents of these states. Non-qualified withdrawals are subject to a 10% penalty
- Contributions can be withdrawn from the account without a 10% penalty. Earnings are subject to 10% penalty
- No impact on financial aid eligibility – assets in the account are treated as parental assets, no matter whether they are owned by the parent or a child
- Less investment flexibility. Most states offer predetermined investment portfolios that may not be suitable or aligned with someone’s goals and risk profile. In addition, annual expenses with 529 plans are higher than with the Coverdell ESA
One of the most important differences between 529 plans and the Coverdell ESA – no contribution limits. Many plans sponsors make sure that the total contributions do not exceed the total amount necessary to pay for college, which is usually $200,000.
In addition, each donor to a 529 plan can contribute up to $14,000 (for 2015) per year without triggering the gift tax. Those who want to make a large contribution to a 529 plan beneficiary, can donate up to $70,000 in a given year without counting toward the gift tax as long as this donor makes no future contributions in the next five years.
As you can see, all these options make a 529 plan a perfect savings vehicle for high-income earners.
How to Get Started?
- Check if your college is eligible
- Compare 529 plans by states and choose the one you like
- Choose an asset allocation: Usually state sponsors offer portfolios with a predefined asset allocation, like age-based portfolios (model portfolios where risk level shifts from aggressive to conservative as the beneficiary ages) or static allocation, where the weight of a specific asset class remains the same all the time. However, some states permit more flexibility by allowing to create individual portfolios based on risk tolerance and objectives. If you decide to create your own individual portfolio, which is a sound idea because you get more control over your funds and lower fees, I recommend discussing it with your investment adviser so he can help you out to choose funds and allocate your money smartly and aligned with your goals
- Set up an account and you are good to go
A Few Notes
- States may impose an extra layer of costs. With that said, pay attention to the fees. With 529 plans, annual expenses may vary from 0.07% and up to 1%. As I wrote here, high fees have a devastating effect on your account growth
- Some states have an enrollment period. Don’t miss your period or you will have to wait postponing compounding working in your favor
A 529 plan is a powerful instrument that is designed to grow your money tax-free and get your kids ready for college. The huge advantage of a 529 plan is no limits: no age limits, no limits on contributor’s income, and very high contribution amounts. However, there are a few drawbacks that make it less attractive than the Coverdell, which are less investment flexibility and higher costs.
Regardless what education savings vehicle you decide to choose, Coverdell or a 529 plan, the only thing I am sure is that you are better off to start it early.