College Savings Plans 101: Commonly Asked Questions Answered

The cost of college continues to rise at a rate that outstrips inflation. It’s no surprise that many parents are starting early to save up for their kids.

“College savings plans can be one way to set aside money over time to help your kids pay for college,” said Dara Luber, senior manager, retirement product at TD Ameritrade. “The more you understand, however, the more likely you are to choose what’s right for your family.”

If you’re trying to figure out college savings plans, here are some of the most commonly asked questions—and their answers.

What Are the Different Types of College Savings Plans?

There are two main types of college savings plans:

• 529 plans
• Coverdell Education Savings Accounts

Luber also pointed out that you can use a custodial savings account on your child’s behalf. However, these don’t have the same tax advantages as an account specifically designed for saving for college.

529 Plans

A 529 plan is designed to allow you to invest toward college and comes with tax benefits. Although contributions to 529 plans don’t come with a federal tax benefit, many states offer a tax deduction when you make a contribution. Additionally, any growth is federally tax-free, as long as it’s used for qualified education costs when you withdraw.

Even if you use a state’s plan, your child isn’t bound to go to a school in that state. Funds from a 529 college savings plan can be used at more than 6,000 higher education institutions in the United States — and can even be used at some foreign universities.

Coverdell ESAs

A Coverdell Education Savings Account (ESA) is also a tax-advantaged account designed to help families save for college expenses. Contributions aren’t tax-deductible, however, any earnings grow federally tax-free as long as withdrawals are used for qualified expenses.

Limits for contributions are lower for the Coverdell than for the 529 college savings plan, however, even though you might have access to more investment choices in a Coverdell account and might also save on fees.

What Are the Differences Between a 529 Plan and a Coverdell?

“The biggest difference between the two is the contribution limit,” said Luber. “With a Coverdell, only $2,000 can be contributed each year, and that’s in total.”

She explained that if parents contribute $2,000 to a beneficiary’s Coverdell in the year, grandparents can’t contribute to the account.

On the other hand, it’s possible to contribute more to a 529 college fund.  For 2019, you can contribute $15,000 per individual without incurring the federal gift tax.  If you’re married and filing jointly, you can contribute up to $30,000 per beneficiary.

“In fact, contributors can even contribute up to $75,000 a year without incurring the gift tax, because they can count the current year and four annual gifts for future years,” said Luber. “A 529 is the only way to contribute so much money without incurring the gift tax.”

Another difference is that you can’t contribute to a Coverdell for a beneficiary who has reached 18 years of age, whereas with a 529, there is no age limit. Plus, if the original beneficiary doesn’t use the 529 funds, you can name a new beneficiary. The case isn’t so simple with a Coverdell.

Finally, your contributions are capped for a Coverdell when you reach a certain adjusted gross income. There are no income limitations for 529 plans.

What Expenses Can College Savings Plans Be Used For?

When you withdraw money from a 529 plan, you can use it for a number of college expenses, including:

• Tuition
• Room & Board
• Books
• Necessary equipment (including a computer)

Recently, it became possible to use up to $10,000 from a 529 to pay for tuition at K-12 schools in some states. However, before you withdraw money for this use, Luber recommended speaking with a tax professional.

A Coverdell ESA can be used to pay for tuition, books, and uniforms. However, Coverdell accounts have always been available for K-12 education costs.

What are the Benefits of College Savings Plans?

529 Plans: Potential Benefits

• Investments can grow tax-free when used for qualified expenses: As long as you use the money for qualified education expenses, you don’t have to pay federal taxes on the withdrawals.
• Higher contribution limit: The higher contribution limit allows families to invest at a higher level.
• The account owner maintains control: If you established and own the account, you remain in control of it. You decide how the money is used for the beneficiary. 
• You can change beneficiaries: It’s possible to change beneficiaries later, so if the original beneficiary doesn’t go to school, or if there’s money left in the account, someone else can benefit.

Coverdell ESAs: Potential Benefits

• Investments can grow tax-free: As with the 529 plan, investments grow tax-free when used for qualified education expenses.
• Flexibility in investment choice: Coverdell ESAs allow for self-directed investment, which can be seen as a benefit to investors who prefer a wide range of investment alternatives. 
• Unlimited usage for primary and secondary school: While new laws may allow for a limited amount of 529 money to be used for primary and secondary education, there are no limits to how Coverdell ESA money can be used for private school costs.

What are the Disadvantages of College Savings Plans?

529 Plans: Potential Disadvantages

• Limited investment choices: You might have access to limited investment options. You can only invest in what’s available through the plan administrator.
• Penalty on nonqualified withdrawals: If the money is withdrawn and not used for qualified expenses, it will be treated as ordinary income. Plus, you have to pay a 10% penalty on the amount.

Coverdell ESAs: Potential Disadvantages

• Low maximum contribution:There’s a contribution limit of $2,000 a year on the Coverdell ESA, and contributions can’t be made to an account after the student reaches age 18.
• Assets must be used up by age 30: Assets have to be used by age 30. If they aren’t used for qualified expenses, taxes will need to be paid on the earnings, along with a 10% penalty. 
• Income restrictions: If you make a certain income, you aren’t eligible to contribute to a Coverdell ESA.
• Penalty on nonqualified withdrawals: Just like with 529s, Coverdell money that's withdrawn and used for nonqualified expenses will be taxed at the ordinary income rate and also be assessed a 10% penalty.

Bottom Line

No matter what account you use, it’s important to save up for college if you plan to help your child cover those costs. If you can grow the account tax-free and get a potential state tax benefit, it can make a lot of sense to consider a college savings plan.

An investor should consider a 529 plan’s investment objectives, risks, charges and expenses before investing.  A plan’s Program Disclosure Statement, which contains this and more information, should be read carefully before investing. 

Investors should consider before investing whether their or their beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program and should consult their tax advisor, attorney and/or other advisor regarding their specific legal, investment or tax situation.