Higher Education Savings Plans

As the first day of school approaches, and your children anticipate returning to the classroom, the thought of investing in a higher education savings plan may have crossed your mind. Or perhaps you are already making contributions to one but have some questions about how the funds can be used. Two of the most popular higher education savings plans are the 529 and the Coverdell ESA. Below are overviews of each, as well as some key differences and advantages.

What is a 529 plan?

A 529 plan, or “qualified tuition plan,” is a tax-advantaged savings plan often used by parents and families of students to save for future education costs. The plans are sponsored by states, state agencies, or educational institutions, which means the sponsor is responsible for choosing the plan manager and determining the plan’s rules and limits. Since the passage of the 2017 Tax Cuts and Jobs Act, 529s, previously limited to only higher education expenses, can now also be used to pay up to $10,000 per year of elementary or secondary school tuition (in some states).

What is a Coverdell ESA?

A Coverdell education savings account is a tax-deferred trust or custodial account designed to help you save for K-12 and college expenses for a family member, friend, or yourself. With these accounts, you are responsible for setting it up and choosing how to invest the money. One of the advantages of a Coverdell ESA is that it can be used to pay qualified elementary and secondary school expenses.

What are qualified education expenses?

Qualified education expenses include tuition, fees, or any other expense that is necessary for a beneficiary’s enrollment or attendance at an eligible educational institution. Some examples of expenses that do not qualify are room and board, insurance, medical expenses, transportation, and other personal expenses.

What are some key advantages of each plan?

Tax considerations

For both the 529 and Coverdell ESA, contributions are not tax-deductible; however, earnings accumulate tax-free, and distributions are not subject to tax, so long as the amount of a distribution does not exceed the beneficiary’s qualified education expenses (including elementary and secondary tuition for the 529 and qualified elementary and secondary school expenses for the Coverdell ESA). If you are contributing to a 529, keep in mind that the annual exclusion for the 2022 tax year is $16,000. This means any contribution over $16,000 will be subject to the gift tax. You can elect to treat a contribution as made over a five-year period, allowing you to make a lump sum contribution of up to five times the annual exclusion ($80,000); however, you will not be able to make another contribution for the next five years.

Additional information

If you contribute to a Coverdell ESA, you have the option of rolling the funds into a 529 plan without tax consequences, as long as the beneficiary stays the same. For either the Coverdell ESA or 529, if you wish to change beneficiaries, the new beneficiary must be a member of the existing beneficiary’s family (529 age restrictions still apply). You can also contribute to both a 529 and Coverdell ESA for the same beneficiary. If you have any additional questions, visit irs.gov for information on the specific rules for each savings plan.

As always, your Southwestern Investment Group advisor is available to answer any questions you may have about funding your child’s education. Contact your advisor today to find out which savings plan is best for you and your family.

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