529 vs. Coverdell: Which is Right for Your Student?

How will you pay for college? Whether you’re a parent or a student, that’s an essential question – one that can loom large even for parents of young children who are still a decade away from college. An education savings plan can help.

At Addition Financial, we love talking to parents and students about their saving and investment options to pay for college. One of the things we get asked often is about 529 vs. Coverdell accounts and which is better to pay for college. 

It’s an important question to ask and answer. Here’s everything you need to know about Coverdell and 529 accounts to help you make an informed decision about college savings.

What is a 529 Plan?

A 529 plan is a tax-advantaged savings account that is designed to encourage parents and students to save money for future education expenses. It’s also known as a qualified tuition plan and there are two types:

1. Education Savings Account – A 529 ESA is an investment savings account that can be used to pay for most colleges or universities, including some colleges outside of the US. Money may also be used (with limits, which we’ll discuss later) to pay for elementary or secondary school expenses.
2. Prepaid Tuition Plan – A 529 prepaid tuition plan can be used to purchase credits at participating colleges and universities. The credits are typically restricted to tuition, meaning that room and board are excluded. Most prepaid plans are for public, in-state schools.

There is no limit on annual contributions to a 529 plan. While contributions are not tax deductible as a rule, they do qualify for the Annual Gift Tax Exemption. The limit for the exemption is $16,000 for 2022, which means contributors can give up to that amount without being taxed.

A contributor who wishes to give more than $16,000 may do so by agreeing to treat the gift as if it were spread out over five years. In other words, a grandparent could give $80,000 and claim the gift deduction as if it were $16,000 per year. Any contributor who chooses to make a 5-year contribution may not make any additional gifts to the same beneficiary until the five years are up.

All contributions are made on a post-tax basis, which means that investments grow tax-free and may be withdrawn tax free. Qualified withdrawals from a 529 ESA may be used to pay for college expenses or for up to $10,000 of tuition at a qualified elementary or secondary school.

What is a Coverdell ESA?

The Coverdell Education Savings Account is an account that allows anybody who meets the requirements to contribute up to $2,000 per child per year to pay for college expenses.

To contribute the maximum amount of $2,000, donors must meet the threshold for the modified adjusted gross income (MAGI) which are as follows:

• $95,000 for single filers
• $190,000 for couples filing jointly

There is an option to contribute less than $2,000 per year for people who make more than these limits but less than the maximum allowable income, which is $110,000 for single filers and $220,000 for couples filing jointly.

If you earn more than the maximum, you may not legally contribute to a Coverdell ESA. However, we should note that businesses may contribute and are not subject to the MAGI limits.

There are two other things you should know about Coverdell ESAs. The first is that if you open more than one Coverdell ESA for your child – or family members – the maximum contribution per donor of $2,000 per child per year is for all accounts combined.

The second thing is that a Coverdell ESA operates like a Roth IRA. Any money you contribute will be on a post-tax basis and will grow tax free. Withdrawals are also tax free, provided they are used for qualified education expenses.

Why Not Contribute to Both a Coverdell and a 529?

There are some differences between a Coverdell ESA and a 529 ESA, and we sometimes have members ask us whether they can contribute to both. The short answer is yes, but here are some details.

You may open both a Coverdell and a 529 account for any beneficiary. However, the gifts to both accounts combined must be less than the annual limit on gifts as determined by the IRS. As we noted above, that limit is $16,000 for 2022 and represents a total allowable gift for any one beneficiary.

Let’s look at an example. A student, Sam, has grandparents and parents who want to contribute to his college education. His parents set up a Coverdell ESA and his grandparents set up a 529 plan for him. If his grandparents contributed $16,000 to the 529 plan in one year, they would not be eligible to contribute to the Coverdell account. However, if his parents contributed the maximum of $2,000 to the Coverdell account, they could still contribute up to $14,000 to the 529 plan.

What Are the Key Differences Between Coverdell and 529 Plans?

Here are a few key differences between Coverdell and 529 plans that we haven’t already covered:

• A Coverdell has more qualified expenses than a 529 plan. For example, you can pay up to $10,000 of elementary or secondary school tuition with a 529 plan, but there is no limit with a Coverdell plan. You can also pay for school-related expenses with money from a Coverdell ESA, including tutoring, books, equipment, supplies and school uniforms.
• There is a wider range of potential investments available with a Coverdell account. While money in a 529 plan can usually be invested in an array of mutual funds chosen by the plan administrator, Coverdell funds can be invested in individual stocks and bonds as well.
• Contributions to a Coverdell account must stop when the beneficiary reaches the age of 18 and must be fully distributed by the time the beneficiary is 30. There is no age limit on contributions to or withdrawals from a 529 ESA.
• The beneficiary of a Coverdell must be changed to another family member of the initial beneficiary to keep funds available after the initial beneficiary turns 30, provided that the new beneficiary is under 30. There is no age limit on withdrawals with a 529 account, however, withdrawals must be used for qualified education expenses to be tax-free.

We have already noted another key difference, which is the annual contribution limit. The lower annual limit for a Coverdell may make it less appealing for people who want to fast-track their college savings.

Can You Roll Your Coverdell into a 529?

Another question that we hear from our members has to do with ESA rollovers. Specifically, they want to know if they can roll a Coverdell into a 529 or vice versa.

It is possible to roll a Coverdell into a 529 plan. If you choose to do so, the rollover can be made tax-free and without consideration of the usual contribution limits. There are three requirements you must meet to do a rollover:

1. The beneficiary for the Coverdell plan and the 529 plan must be the same.
2. You may do only one rollover per 12-month period. However, there is no limit on trustee-to-trustee transfers.
3. Rollovers not made through a trustee-to-trustee transfer must occur within 60 days.

We should also note that a Coverdell ESA can be transferred to a beneficiary’s former spouse as part of a separation or divorce agreement. In such cases, the transfer is not taxable.

It is not possible to roll the funds from a 529 plan into a Coverdell plan. 

What Are the Benefits of Converting a Coverdell to a 529 Plan?

There are several advantages to converting a Coverdell account to a 529 plan:

• You expect your income to rise. Because of the income limits for contributions to a Coverdell account, it may make sense to convert your Coverdell to a 529 plan if you expect your income to exclude you from making contributions (or from making the maximum contribution).
• You want to contribute more each year. Even if you meet the income requirements for a Coverdell, your contributions are limited to $2,000 per year per recipient. The relatively low limit may make it difficult to save what you need.
• Your child is about to turn 30. If there is money left in your account and the beneficiary is about to turn 30, you will need to do something to ensure that the money is usable, even if it ends up being for another recipient. As noted above, the 529 must have the same beneficiary as the Coverdell plan; however, you can change the beneficiary of the 529 to a relative after the rollover is complete.
• Your state offers a 529 tax benefit. 30 states offer a state income tax deduction for 529 contributions to a state-sponsored 529 plan. (Note: Florida does not have an income tax, so there is no tax benefit in Florida; however, the Florida state plan has one of the highest total contribution limits at $418,000.)
• Your Coverdell plan has high fees. Fees vary from plan to plan and decrease the total amount you have saved.

If any of these circumstances apply to you and you have a Coverdell account, you may want to consider a 529 rollover.

Both 529 plans and Coverdell plans present tax advantages and a way to save for your child’s college education. You can use the information we’ve provided here to make an informed decision about which plan is right for you.

Are you looking for an affordable Coverdell ESA to save for college? Addition Financial can help! Click here to read about our Coverdell ESA and open an account today.