(LifeWire) - For people who are saving money for education, the Coverdell education savings account option continues to plug along despite the popularity of its cousin, the so-called 529 plan, and with good reason. Despite the two plans' nearly identical purpose - to give Americans a tax-advantaged way to save for education - they come with some crucial differences.
First, let's look at the Coverdell. Named after the late Senator Paul Coverdell of Georgia, the program is an updated and expanded version of what was once known as an education IRA.
Here's how it works:
Annual contributions are capped at $2,000 per beneficiary. They can come from any source-Mom, Dad, Grandpa Joe or the nice man on the bus-but if the total exceeds $2,000, the IRS will slap a 6% tax on the excess.
Contributions are not tax-deductible. But any growth in the investment is tax-deferred, and money can be pulled out tax-free as long as it is used for qualified education expenses, which include items such as books, tuition, room and board and necessary equipment, such as a laptop computer.
Money can be withdrawn to cover approved expenses for kindergarten through 12th grade, as well as higher-education expenses. Approved expenses could include private-school tuition or an after-school tutor.
The money has to be used before the beneficiary turns 30. If the beneficiary reaches 30, or if the money is used for anything but education expenses, the IRS will levy a 10% penalty plus regular income taxes on the amount pulled out. There is one exception to the age limit: Special-needs beneficiaries can continue to draw from their accounts, tax-free, to cover approved expenses after the cutoff age. Contributions can also be made for a special-needs beneficiary after he or she turns 18.
Compare and Contrast
As a comparison, 529 plans also offer tax-free growth and tax-free withdrawals for approved expenses, although they offer no tax break for the initial contribution. Both options involve a 10% penalty on withdrawals for non-approved expenses, and both also allow for a beneficiary change. If the original beneficiary decides that further schooling is not for him or her, the account can be rolled over to a qualified relative.
Beyond that, precise distinctions can be difficult to draw because Congress allowed each of the fifty states to determine some specifics about the respective 529 plans, resulting in rules that vary slightly (or possibly, a lot) from one area to another.
Having said that, each type of plan has a broad set of advantages and disadvantages.
Advantages of a Coverdell
- Flexibility: Coverdell money can be spent on expenses for kindergarten through 12th grade; 529s are limited to higher-education expenses only.
- Wider investment choice: Coverdells must be held by a bank, a brokerage or some other institution approved by Federal law to handle them. Depending on the trustee chosen, investment choices in a Coverdell can be very broad, including stocks, bonds, mutual funds and nearly any other type of investment vehicle offered by the trustee. Most 529 plans limit their investors to only those options provided by their plans. Those choices are often as narrow as the limited selection of mutual funds offered by only one company. In a handful of states, 529 investors can opt instead for prepaid tuition plans.
Disadvantages of a Coverdell
- Income limits: Coverdell contributions are limited for single taxpayers with adjusted gross incomes higher than $95,000 and for joint filers who bring in more than $190,000. They phase out altogether for single filers with adjusted gross income over $110,000 and for joint filers with AGIs over $220,000. Contributors to 529s face no income limits.
- Contribution size: Coverdells come with a strict $2,000 per beneficiary contribution cap. Some 529 plans will allow contributions as large as $300,000. Under some circumstances, you can contribute up to $55,000 in a single year without incurring a federal gift tax.
- Age cap: Unlike Coverdells, 529 plans allow contributions to accounts for beneficiaries over age 18 and do not require withdrawal at age 30.
