Financial Friday: Saving for your Child’s Education Part II

529 Savings Accounts & Coverdell

*by Ratna

Last time, we talked about estimating how much you think your child will need for education and other expenses.   This part of the series addresses 529s and Coverdell Accounts and in Part III, I will close out this series with Custodial Savings Accounts.
Miss Part I of the series ? Just click here!

A comment on the last article was that an entire financial portfolio is important to maintain and this is definitely true but if you do nothing else, here are some popular ways to “invest” and save money for education:

First, there’s the 529 Plan, named after Section 529 of the IRS Code.  For tax and other benefits, it is worthwhile to invest in a 529 in your state of residence but you could also invest in other states.  Take a look at your state’s benefits because some states offer matching contributions and other incentives to residents of that State.  There are two types of 529 plans- prepaid (only 11 states offer this and Colorado is not one of them) and savings.  Prepaid plans allow you to purchase tuition credits at today’s rates to be used in the future.  Savings plans are the most commonly offered and are different from prepaid in that all growth is based on market performance of the underlying investments- typically, mutual funds.[1]

We have a savings 529 for both of our daughters, and we put yearly contributions in which are tax deductible (but only on our state of Colorado taxes).  If we had 529s in another state, we could not get to deduct that on Colorado state taxes.  Other benefits of a 529 plan is that the principal (the money you put in) grows tax-deferred and when your child receives funds  for qualified college costs, that is also tax-exempt.  For the parents who worry their kids will blow their savings on booze and drugs in college, worry not.  The parents or the donor who established the 529 maintains control of the account so the college kids cannot withdraw as they please.   If things are not going well, the donor can even reclaim the funds but subject to a 10% penalty unless certain conditions are met (see the link below to determine if you’d pay the 10% penalty).   In some cases, if you do not spend the money on qualified expenses, you may also have to do a recapture with the State where you claimed a tax deduction so check your 529 and State rules before you make decisions to withdraw.  Another advantage to 529 accounts, especially if you have multiple children, is that 529s are transferrable so if your son or daughter earns a scholarship or full-ride and decides not to use it, you can transfer it to siblings, parents, grandparents, and even to first cousins.   There is no age-limit on use as long as the expenses qualify.  Also, keep in mind that room and board is a qualified expense but if your child lives off-campus, then they only receive an amount up to what room and board at the University would have cost.

Like any investment or savings plan, there are pros and cons.  Of course, the pros are discussed above but some of the cons are that you cannot, like investments, move the money around or choose where to invest it.  The State or company that operates or owns the 529 plan can generally invest in mutual funds and you are limited by the IRS to only a single re- allocation or exchange per year.  For example, in a 401K or IRA, you can change what you invest in (go from one of type of fund to another etc.), but in a 529, you get to only make this decision once a year.  Another drawback to 529s is that it counts against you (the parent) or the kids when applying for financial aid so it is considered income.  So, if you are planning to have your child apply for student loans or Pell and other Educational grants (if Congress does not eliminate them altogether here in this term), then, you may want the owner of the 529 to be a grandparent or immediate uncle/aunt who may not have kids of their own to avoid this account being counted as “income” for loan or grant purposes.  Additionally, keep in mind if you are in the upper-income brackets, the federal tax regulations and rules limit how much money you can “gift” and 529s, are unfortunately, considered a “gift” and there are limitations and rules on that.  Please check with your accountant if you plan to contribute $130,000 (married filing joint) over a 5-year period or $65,000 (filing single) over a 5-year period.   Another con of this type of account is the fees you pay for management.  Check your specific plan for fees.  Fees should not be high and if they are, look at other options.  As a general rule, the fees on the 529 plan should be lower than brokerage fees but if it is not, consider other options or do more research.

Procedurally, like any other account, you have to fill out paperwork.  If you google 529 plans in Colorado, tons of options come up but talk with your friends and see what company they use.  Fill out your child’s enrollment today and start contributing – you’d be surprised how helpful an account like this can be for the future.

A second popular option is the Coverdell Education Savings Account (ESA) or Coverdell ESA.  Codified at Section 530 of the IRS Code, the Coverdell ESA provides the same tax benefits as the 529 Plan but a Coverdell ESA can also pay for elementary and secondary school education in addition to college.  So, if you plan to pay for private schools, Coverdell ESA may be right for you and a good tax shelter for your money for the younger years of your child’s education.   Just like the 529 Plan, the parents or owners  (donors) of the 529 control the money so your children cannot tap into it and use it at will.  Also, just like the 529, there is a transfer provision which allows the naming of new eligible beneficiary without taxes or penalties.

But, here are some important differences between the 529 Plan and the Coverdell:   Coverdell ESAs have lower maximum contribution limits; currently only $2,000 can be contributed per year per child, while 529 plans generally have no restrictions on contributions, up to the maximum lifetime contribution.[2] One of the biggest differences and advantages of the Coverdell ESA is that it allows almost any investment and a broader range including stocks, bonds and mutual funds while 529s are very limited.  Another advantage and big difference is that you can move the money around several times a year and the same rules that apply to IRAs apply to ESAs.  Another important difference is that there is no age limit to 529 plans so if the child decides to pursue post-graduate doctoral studies, the 529 can be used.  ESAs must be disbursed on qualified educational expenses by the time the named beneficiary is age 30 in order to avoid tax implications and fees.  Of course, the obvious difference is that Coverdell permits withdrawing for educational qualified expenses from elementary school and secondary school through college.  529s only allow university and college qualified expenses.  Also, another big difference is that the income level of the donor may “phase out” contributions to the Coverdell ESA but will not affect 529s.  Anyone can contribute to a 529 and there is no “phase out” for contributions.

Next time, in Part III, I will address Custodial Accounts- these can be a great tool and can be set-up in addition to the savings methods discussed above.

By Ratna Gupta*

*Ratna Gupta is a wife, and mother of two who lives in Colorado, and blogs useful financial tips, consumer reviews, and mommy experiences at .  Check out this and other great articles at her blog, Get Clued In!

Disclaimer: All parts of this series were written by the author in her personal capacity and not attributed to her profession, or any organizations, employers, or the like that author is affiliated with. The author is interested in these topics and blogs for recreational purposes and not for financial gain. All views and opinions are of the author and not attributable to any company and not meant as an endorsement to any company or organization. Most importantly, author is not a financial expert, tax attorney, estate planner, or accountant, nor works in the financial planning field. This article is written solely for the purpose of sharing information and knowledge with the readers. All readers should consult with their own attorney, tax planner, financial or estate planner, and/or accountant prior to making investment decisions. The author is not liable and will be held harmless for any investment loss or risk undertaken as a result of opening any of the accounts aforementioned.



The Custodial Accounts I will talk about next time are not just for education so keep that tid bit in mind as we go into next week to close out the series. Look forward to your comments and questions!

I was wondering if there are any management fees with 529 or Coverdell accounts?

Steve- good question. Yes, my research indicates and personal experience as well, that there are fees. On the 529s, this is the biggest CON- sometimes the fees can be higher than the performance of the investment plus since you are limited to only one transaction in the 529 per year, you can lose a lot more than gain if the fees are high. On the Coverdell, there are management/investment fees as well but because you can move the money around more, you may see more gains to help offset the fees.

Can you have both? Because it seems like the Coverdell offers more management of your investment, so perhaps max that out and if you have more to invest then move to 529? Also, how do Roth IRA’s fit into the picture? That’s where we’re putting our college $ for now.

Very thorough, thank you Ratna!

Sorry- I have been posting responses a few times but hope this shows up.

Thanks, Daria- great Questions.
(1) First, YES -you can have both accounts and even ROLL a Coverdell into a 529. So it is a good deal that you can get the tax advantage later on the Coverdell.

(2) Correct while the Coverdell offers flexibility in moving the money around several times a year, keep in mind you can only contribute $2000 per child per year.

(3) The reason I do not address ROTH IRA or 401K in this is because To me and to most people, ROTHS are for retirement – MY RETIREMENT but there are a lot of people using them for college savings. I found a great blog on advantages and disadvantages:
Check it out!

Advantages of the ROTH are: 10% penalty waived (see the IRS rules though – there is a 5-year minimum requirement of the money staying in that ROTH prior to withdrawal) and also, if your kid does not go to college, you can then stop worrying about losing the money and use towards retirement.

BUT here are the CONS: you can contribute $5000 a year to ROTH (maybe- if you have over $179K AGI per year combined you cannot contribute ANYTHING), but in a 529, you can contribute as much as you want per child. This is HUGE for dual-income middle class families who get taxed to death but then also have to save for college.
Another disadvantage of the ROTH for college v. 529/Coverdell is that you ARE TAXED on your withdrawals when you withdraw so if you are not yet retired, you will be in a high tax bracket and have to pay taxes on all of that- THAT IS HARSH if you are in a 20-25% bracket even.

Also keep in mind that you are reducing YOUR retirement in place of college spending and that may stink 10 years later for you or you will have to work longer if you do not have a 401K or other retirement savings.

I am not a tax advisor, accountant or financial planner, but I would recommend you talk with one about your specific situation. You know your AGI (you just did your taxes), and you know your retirement situation or what it should be… but my recommendation is to keep retirement separate from educational savings if you expect your kids to go to college.

Just got another question from a twitter follower:
I’ve always wondered how tied to the state a 529 is. What if you move or child goes to private or out-of-state college?

ANSWER: the only advantage to contributing to your state’s 529 is the immediate tax benefit or matching funds (if you have a state that matches). The kid can attend ANY School in the nation- Harvard to Community College. If you move, no biggie. You can keep both – ie. Colorado’s account is still there and then you can open a new one in the new state to get the tax benefit or deduction. Make sense?

I think that you aren’t taxed on Roth withdrawals because they are taxed before they are deposited so any gain is tax free – that is the fundamental difference between a Roth and a traditional IRA. So, for us, we have 401K with work that is matching and set for our retirement – then add to a Roth IRA figuring we can use it for college or retirement depending on how things turn out. My parents set up 529’s for the kids – more & more grandparents are footing the college bill – so I think we have all options covered except for the Coverdell. So basically, retirement comes first, but if we have more then we put it into Roth for either college or retirement depending.

I may have to look into a Coverdell. I didn’t realize you could use 529 funds out of the state that they were saved in – good to know.

GREAT thorough insight into the differences – thank you Ratna!

That’s great Daria that you can contribute to a ROTH- except for the years I had maternity leave and did Leave Without Pay, we cannot contribute much to the ROTH so like I said for dual wage earners (both middle income), it is tough to contribute to the ROTH- we get phased out even if we make combined $100K AGI (this is after our deductions)… we start getting phased out.
So for us, ROTH is small at best and while we have our work 401Ks for retirement, we definitely do not get the nest egg we need for the kiddos unless we do 529s and other savings like Custodial Accounts which will be addressed next Financial Friday. You are very knowledgeable and the best thing is that you are doing the right thing- you are saving!!!! I need to learn a few things from you.

And yes, Daria- forgot to add that you can use the 529 money for EDUCATION anywhere- as long as it is college, community college, etc… no need for accreditation even. It just has to be for the qualified expenses- the 529 plans list those: Room, Board, Tuition, Fees, and even Books/Supplies.

Thanks so much for responding to my questions. It’s pretty difficult to wade through all the options some times. But I don’t feel nearly as knowledgable as you! I haven’t even looked beyond the Roth because until we are maxing that out, it doesn’t seem to make sense.

I am really enjoying these insights and tips – great series Ratna!

This book changed my approach to paying for college. We have been faithfully putting money into our children’s college funds and funding our retirement, but this book really opened my eyes to the big picture by asking two important questions, “How close to retirement age will you be when your last child graduates? And when he or she does graduate, how financially ready will you be for retirement?”

This is not a last-minute, quick fix for scrounging up money when your child is a senior. But for those late in the game (a child in high school), it does do an excellent job of explaining how financial aid works, why you should fill out the application for aid even you’re sure you won’t get any, and what to do with your assets (and when) to increase the possibility that you will get aid. It also gives advice on working with colleges to see if your child can get a better aid package than the one he or she was initially awarded.

I also really liked the fact that the book isn’t just about getting financial aid. Just because you don’t qualify for federal aid doesn’t mean that paying for college is easy. The author does a nice job giving examples of strategies for a variety of income levels. We won’t qualify for need-based aid, but I learned that there is more I can do in terms of our savings and investments to help pay for college.

The book also isn’t just about the money. I appreciated the discussion on the importance of selecting the right college, not just sending my child to what she thinks is her dream college. I have changed my mind about the importance of the college visit prior to making a decision. I didn’t do this when I chose a college, but will now think of that as an investment rather than an optional, possibly unnecessary expense.

Overall, this book gave me a much greater appreciation for the interconnectedness of my two most important financial goals in life and very useful strategies for working toward fulfilling both. I think they should hand this book out at the doctor’s office along with “What to Expect When You’re Expecting.” We have done a decent job with our finances over the years but I wish I had had this epiphany back when my first child was a baby. I have highlighted passages in this book, which I never do, and will keep it close by until my last child orders her collegiate cap and gown.

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