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529 Plan vs. Coverdell ESA: What's the Best Way to Save for College?

If you’re a parent, paying for college can put a serious strain on your budget, especially as tuition prices continue to climb. According to the College Board, the average cost of tuition at a public four-year university was $31,107 for the 2013-14 school year. The cost jumps even higher for students enrolled at private colleges. Saving early and often can soften some of the blow but you have to make sure you’re stashing your cash in the right place.

Find out now: What will it cost to go to school?

The most common ways for parents to save for college are 529 plans and Coverdell Education Savings Accounts. If you’re not sure which one is right for you, here’s a brief breakdown of how each account works and what the benefits are.

529 Plan Basics

A 529 plan, also known as a qualified tuition plan, is a tax-advantaged account that you can set up on behalf of a designated beneficiary. Anyone can be a designated beneficiary including a relative, friend, yourself, etc. There are no age restrictions to consider when choosing a beneficiary.

All 50 states offer at least one 529 plan and some states offer more than one. You don’t have to be a resident of a particular state to participate in their plan. Depending on the state, you may be able to choose between a 529 savings account or a prepaid tuition plan. With a prepaid plan, you can pre-purchase future college credits at current tuition rates.

Coverdell ESA

A Coverdell ESA also offers some tax benefits but this type of account works differently than a 529 plan. For starters, you can only open a Coverdell account for someone under age 18, unless they qualify as a special needs beneficiary. If you open an account for a minor child, you can’t make any contributions past their 18th birthday (unless the person is a special needs beneficiary).

Unlike 529 plans, you have to meet the IRS income guidelines in order to make contributions. Currently, individuals can only contribute money into a Coverdell account if their modified adjusted gross income is less than $110,000. The income cap doubles to $220,000 for married couples filing jointly.

Contribution Limits

With a 529 plan, each state sets its own limit on lifetime contributions. Many plans feature contribution limits that exceed $300,000 but you’ll have to check with your plan administrator to find out how much you can chip in. You also need to keep the gift tax in mind when making contributions. As of 2014, you could gift up to $14,000 to an individual without having to pay gift tax. The limit doubles to $28,000 for married couples.

How to Give Money to Students and Avoid Gift Tax

The annual contribution limit for a Coverdell ESA is currently fixed at $2,000 per beneficiary. The $2,000 limit is cumulative, meaning it applies to the total contributions made to more than one Coverdell account for the same beneficiary.

Distributions

There’s no cutoff date for when you need to begin taking money out of a 529 plan but there are specific guidelines that cover distributions. Any withdrawals you make must be used to cover qualified education expenses at an eligible institution. An eligible institution is any school that’s able to participate in federal student aid programs.

Qualified expenses include tuition, fees, books, room and board and any additional necessary costs for a special needs student. If you use the money in a 529 account for anything other than education expenses, it’s considered a taxable distribution. You’ll have to pay income taxes on whatever you take out, along with a 10% penalty.

The same distribution rules apply to Coverdell accounts with one key exception. All the assets in the account must be withdrawn within 30 days of the beneficiary’s 30th birthday, unless they’re a special needs beneficiary.

Which is Better?

A 529 plan offers higher contribution limits as well as more flexibility when it comes transferability and your range of investment choices. You also don’t have to worry about your ability to contribute being limited by your income. On the other hand, a Coverdell ESA offers relatively the same tax advantages, provided you adhere to the distribution guidelines. When you’re weighing your options, it helps to look at your overall savings goals and your current tax situation to see which one is the best fit.

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Photo Credit: flickr

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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