College Savings Plans (12/11/2007)

Due to the recent birth of my first child (baby boy – if you’re interested in knowing), I’ve done some research on college savings plans. So, I thought I’d pass along what I’ve learned to you. Hopefully, I’ll make it a little easier to understand. To get started, I’ll outline the two primary college savings plans offered, the Coverdell ESA and the 529 Plan. Then, I’ll go into specific differences so you can choose which one would be best if you were going to begin an education savings plan.

Coverdell ESA
The Coverdell Education Savings Account was referred to as an Educational IRA until 2002, when they made a lot of changes to the program, including the name. Here are some highlights:
1. You can contribute up to $2,000 annually per child.
2. Contributions are not tax-deductible.
3. Earnings in the account grow tax deferred, meaning you don’t have to pay any taxes on the gains.
4. Qualified withdrawals are not taxed as income.
5. If not used for college, all funds must be distributed to the child when they reach age 30 (no penalty). All withdrawals prior to the child reaching age 30, must be for qualified educational expenses.
6. Funds can be used for elementary, secondary, or higher education.

A Coverdell ESA can be established at almost any brokerage firm. They will typically charge a small annual fee to hold the account. You can invest the money in almost anything as there are no restrictions that I could find. The account owner will be called a “custodian” and the child will be named the “beneficiary”. The custodian does not have to be a parent. The custodian makes all of the spending decisions.

Be careful if more than one person opens a Coverdell for the same child as the program only allows $2,000 TOTAL in contributions annually per child. If you contribute more than $2,000, there are penalties involved. If the grandparents want to give money for junior’s education, have them give it to you for the Coverdell so you can keep track of all contributions. If they give you more than $2,000, open a 529 Plan.

529 Plan
In Missouri, this is also referred to as the Missouri MOST plan. Most states have a 529 Plan and vary slightly from state to state. Here are the highlights of the Missouri 529 Plan:
1. You can make contributions until the total balance in the 529 Plan reaches $235,000 for one beneficiary. However, only $8,000 is tax deductible per person ($16,000 if you’re married filing jointly and both spouses are owners of the plan).
2. Earnings on the account grow tax deferred and you will not owe income taxes on withdrawals that are used for qualified higher education expenses.
3. If not used for higher education, you can transfer the account to another beneficiary or withdrawal the funds with a 10% penalty, plus taxes owed because unqualified withdrawals will be reported as regular income.
4. There are 15 different investment options available, and three that automatically adjust as the beneficiary gets older.
5. Funds can be used for any higher education expenses, including certain room & board expenses, books, and class fees. Higher education includes community college, trade schools, and graduate education.

The 529 Plan also allows several contribution methods, including payroll deduction. A brokerage firm can help you set up a 529 Plan or you can go to your state’s website and open the account directly. A brokerage firm will likely charge a one-time fee to open the account or an annual fee to help maintain it. The account is set up with an account “owner” and an account “beneficiary”. Like with the Coverdell, a parent does not have to be the owner of the account.

Major Differences
If you need help deciding which plan is best for you, you need to understand the major differences. I’ve highlighted them below:
Contributions: With the Coverdell, you can only contribute $2,000 annually per child. The 529 Plan does not have this limitation.
Educational Expenses: You can withdrawal from the Coverdell for any educational expense from elementary to higher education. The 529 Plan can only be used for higher education.
Withdrawals: Withdrawals from the 529 Plan must be used for higher education. Withdrawals not used for higher education are reported as regular income subject to taxes plus a 10% penalty. Funds from a Coverdell must also be used for educational expenses, however if funds remain after college, the account can be distributed to the beneficiary at age 30 without penalty or taxes.
Investments: You can invest funds in a Coverdell in whatever you want (mutual funds, bonds, stocks, etc). The 529 Plan offers 15 different investment options with different investment objectives. Therefore, the 529 Plan is much more restrictive.

No matter what plan you use, it’s important to save for college as soon as possible. Compounding investments, especially tax free, is a thing of beauty. The only benefit these two plans have in common is that the earnings grow tax free. Investments grow much faster if you don’t have to pay taxes on the earnings each year. This is the same reason why 401(k) plans and IRAs are popular savings vehicles.

Here are a couple of scenarios to illustrate the growth potential:
1. If you start with $10,000 and make monthly contributions of $100, assuming an annual rate of return of 7%, the account would have $78,197 in 18 years. If you increased the contributions to $200 each month, you’d have $121,269 in 18 years.
2. If you started at zero and made $100 monthly contributions, assuming an annual rate of return of 7%, the account would have $43,072 in 18 years. If you increased the contributions to $200 each month, you’d have $86,144.

Please don’t hesitate to make any comments or ask any questions regarding this topic.