The Best College Savings Plan You May Never Have Heard Of
Comparing a Coverdell Education Savings Account to a 529 college savings plan might seem like putting a Big Wheel up against a Harley Davidson.
According to the Investment Company Institute, 529 plan assets totaled more than $224 billion in 2014. By comparison, Coverdell assets amounted to relatively paltry $7 billion. It's likely that many college savers have never even heard of them.
One big reason for the disparity is that a Coverdell—formerly known as an Education IRA—allows for a maximum $2,000 a year in savings per beneficiary. By contrast, 529s have a $14,000 annual contribution cap and total savings limits well into six figures.
Contribution limits aside, Coverdells do have a few things going for them, and many financial pros say they can still have a place in your overall investment program.
When Coverdells pay
Like 529 plans, Coverdell accounts don’t reward you with a federal tax deduction for your contributions, but your account’s earnings can be withdrawn tax-free if they’re used for qualified education expenses.
What’s more, the kinds of expenses that qualify aren’t limited to higher education—which is one of the most compelling reasons to fund a Coverdell.
“The key word is higher education,” says Clint Haynes, a financial planner in Lee's Summit, Mo. As he points out, “529 accounts can only be used for college, while the Coverdell can be used for both college and private school.” That includes both elementary and secondary schools.
Other Coverdell advantages include a greater range of investment options (529 plans often limit your menu) and lower expenses than many 529 plans. A study by the website SavingforCollege.com showed that the 10-year cost of a $10,000 investment in many states’ 529 plans could easily exceed $1,000 or more.
Coverdells also let you “make unlimited investment changes, unlike 529 plans which limit you to two changes per year,” notes Glen Ellyn, Ill., financial planner Joseph Orsolini.
When they don’t
But Coverdells are far from an education expense panacea. For one thing, there are income limits that may make you ineligible to contribute. Single tax filers, for example, must have no more than $95,000 in annual adjusted gross income to make a full contribution; joint filers top off at $190,000. By contrast, 529s have no income limitations.
There are some other drawbacks, as well. Unlike 529s, Coverdell assets are not revocable. That means parents can't take the money back (with taxes and penalties) if they need it for other purposes, such as a financial emergency. However, similar to a 529, the account's beneficiary can be changed to another family member under age 30. But any unspent funds remaining in a Coverdell account must be used when the beneficiary reaches age 30, and they may be subject to taxes and a 10% penalty if they don’t go toward qualified education expenses in that year.
Coverdells can also prove restrictive if more than one relative wants to contribute to a child’s education. As Minneapolis financial planner Matthew Cosgriff points out, if parents deposited a mere $100 a month into a Coverdell, that would limit other family members to $800 should they wish to tack on a year-end contribution.
Still, Coverdells offer a degree of flexibility that 529s do not, something that Orsolini leverages by regularly putting $100 into each of his two young sons’ Coverdell accounts. “Saving in a Coverdell gives me the flexibility to use the proceeds if I should decide to send my kids to a private high school,” he says. “K-12 funding is not an option with a 529 plan.”
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IN CASE YOU'RE WONDERING... Who Was Coverdell? Paul Coverdell (1939-2000), a Republican U.S. Senator from Georgia, was a champion of the Education IRA, which was passed into law in 1997 and first became available to Americans in 1998. He died in office of a cerebral hemorrhage in 2000, and a year later, the plans were renamed Coverdell Educational Savings Accounts in his honor. Sen. Coverdell attended Georgia State University and graduated from the University of Missouri. —Greg Daugherty
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