Education Savings Vehicles

As the new year begins, so does the annual season of college acceptances and rejections. Many outbound high school seniors may soon find themselves holding a single sheet of paper with shaking hands and bated breath, eyes fervently scanning for the only detail that truly matters: Did they get in? In today’s hyper-competitive environment, being accepted into college is still an accomplishment worthy of celebration. Like most celebrations, however, the fun ends once the bill comes.

Since 1980, the median cost of college tuition has increased by nearly 260%. In the same timeframe, other consumer goods saw a price increase of 120%. This disparity between the cost of college and other common expenses illustrates a much larger issue: for many Americans, college is simply unaffordable. Besides taking out student loans, what recourse is available to students? Is there anything a student can do to make the money they put toward tuition work harder for them?

Thankfully, there are a few options. Federal and state governments have established special, tax-advantaged savings vehicles designed to pay for qualified higher education expenses. Two of the most common education savings plans, the Coverdell ESA and 529 college savings plans, offer federally tax-free distributions when used for qualified education expenses. Considering the similarities between Coverdell ESAs and 529 plans, it can be difficult to identify their differences and the advantages each plan has over the other.

Qualified tuition programs, commonly called 529 plans, are education savings vehicles established by states or state agencies, and can only be applied without penalty to qualified postsecondary institutions. 529 plans enjoy tax-free distributions for qualified education expenses. Qualified expenses for 529 plans include room and board, expenses for special needs services, and the purchase of any computer or peripheral equipment used primarily during the years a beneficiary is enrolled. This grants a much wider variety of uses at the college level. Some states, like Michigan, also offer fairly sizeable state income tax deductions for qualifying contributions. While 529 plans have no annual contribution limit, total plan balances are limited by an amount set by each state. It is also worth noting that contributions are considered gifts, and are thus subject to the annual gift tax exclusion. This means contributions are generally tax-free when total gifts between the contributor and the recipient are less than $14,000 for the year, but may be taxed if in excess.

A Coverdell ESA, or CESA, is a custodial account designed to pay the qualified education expenses of a designated beneficiary. It can be opened at most financial institutions in the United States for a beneficiary under the age of 18, or any beneficiary with special needs. Qualified education expenses for a CESA are expenses required for enrollment or attendance of a qualifying elementary, secondary, or postsecondary school. This ability to use a CESA at an elementary or secondary school provides a distinct advantage over 529 plans. CESAs typically also have more investment options than 529 plans, at a lower expense ratio. That’s about where the advantages over a 529 plan end, though. CESAs are subject to a $2,000 annual contribution limit, which is gradually reduced to $0 after a certain income threshold.

Coverdell ESAs and 529 plans each have their own distinct uses. For more information on the intricacies of each plan, and how best to fund education in your unique situation, contact your financial professional.