Understanding the Difference between a 529 and a Coverdell Account

A 529 College Savings Plan and a Coverdell Educational Savings Account are both structures to help people save money toward educational expenses. While both plans have their own advantages, they are not the same. Review the differences to see which plan makes more sense for your situation.

A 529 plan refers to the section of the Internal Revenue Code that establishes its parameters. It is similar to a Roth IRA in that it is funded with after-tax dollars, but does not incur income taxes if the funds are eventually distributed to pay for eligible higher education costs.

There are 529 plans in all 50 states. Once you create a plan, the investments are administered by an agency of the state or a professional manager hired by the state. You only need to make the contributions. It is possible to invest in a 529 plan in any state, even if you live in another state, and the plan beneficiary goes to college in yet another state. Income tax benefits on a state level vary among states, so you can investigate the rules for a particular state before making a final decision.

The person who establishes a 529 plan retains control of the funds in the plan and directs when they will be distributed. There is no time limit on withdrawals. There is no tax reporting until withdrawals from the plan begin. If you decide to cancel the plan and recover the funds, you will be subject to income tax on any earnings and a penalty for a “non-qualified” withdrawal. You can change the beneficiary to another eligible family member whenever you like. There are no age or income restrictions. Contribution limits are usually between $100,000 and $350,000.

Fees and maintenance expenses for 529 plans will vary from plan to plan. Non-residents may pay higher fees than residents. Plan investment structures can be conservative or risk-tolerant, and you should choose a risk level with which you are comfortable. Specific plan provisions will vary somewhat from one state to another, so it is important to review a state’s plan structure carefully.

The Coverdell ESA is also an after-tax contribution that does not incur federal income tax for qualified distributions. There are no state income tax benefits associated with the Coverdell plan. To make contributions to a Coverdell ESA, the beneficiary must be under 18 years of age. The contribution limit is $2,000 per year from any source, and there are income limitations for contributors. The contribution limit is scheduled to drop to $500 per year in 2011 unless legislation is enacted to extend the higher limit.

The funds in a Coverdell plan will be paid to the beneficiary either as qualified or unqualified expenses; they cannot be recovered by the contributor as is possible in a 529 plan. The plan assets must be withdrawn by the time the beneficiary reaches age 30 or they will be subject to taxes and penalties.

One specific current advantage of the Coverdell plan is that expenses for private kindergarten through twelfth grade are eligible through 2010, where the 529 plan covers only higher education. However, unless legislation is passed to extend that provision, that benefit will cease in 2011.

If the legislative changes do not happen, it will still be possible to transfer funds from a Coverdell to a 529 plan, so persons who have already invested in a Coverdell plan will not be permanently disadvantaged. For detailed tax information, see Internal Revenue Service Publication 970.