529 Essentials: 529s vs. Coverdells

This week, we will compare and contrast 529s and Coverdell Education Savings Accounts.

Two Basic Types of Investment Vehicles Designed for Post-Secondary Expenses: 529 plans and Coverdell Education Savings Accounts. Both investment types allow families to save money for education with tax exempt asset growth and tax-exempt distributions if used for qualified expenses. Additionally, distributions from 529s and Coverdells are considered an asset of the parent in terms of financial aid, which provides them with beneficial FAFSA treatment in comparison to assets saved in taxable accounts. While 529s are offered by states, Coverdells are offered by banks, brokerage firms, product providers and any other IRS-approved entity that decides to offer them. Despite more firms being allowed to offer Coverdells, several firms have stopped offering them due to their comparative limitations. Alternatively, more 529s are being offered by an increasing number of providers. Despite the trend in usage, Coverdells still have their place in financial planning. For example, the money saved in a Coverdell can be used for elementary, secondary and postsecondary levels of education while 529s can only be used for postsecondary levels of education such as college or graduate school. Therefore you as an advisor can provide value by knowing these differences and selecting the right investment vehicle based on the unique needs of your client.

Market Sizing: As of December 2015, 529s allowed 12.7 million families to save over $253 billion in assets based on data by Strategic Insight. Of that, 11.6 million families saved over $230 billion in 529 savings plans while 1.1 million saved over $23 billion in 529 prepaid accounts. In addition to the $253 billion in 529s, Coverdells allowed families to save approximately $22 billion in assets as of December 2015. Together families have saved an estimated $275 billion in dedicated education savings vehicles as of the end of 2015.

Compare and Contrast:

• Eligible Institutions: While assets in 529 savings plans can be used for the vast majority of colleges and universities in the U.S. and many abroad so long as they are eligible for financial aid from the U.S. Government, Coverdells can be used for elementary, secondary and postsecondary levels of education. Therefore Coverdells provide a broader coverage area of qualified expenses by including Kindergarten through 12th grade (K-12).
• Qualified Expenses at Eligible Institutions: 529 savings plans are be used for any qualified higher education expense such as tuition and fees, books, supplies and computer technology. Coverdells are similar in that they can be used for similar costs in elementary and secondary schools, but also include academic tutoring, uniforms, transportation and special day programs in connection with the school. Lastly, Coverdell and 529s are similar in that they can be used for room and board at their eligible institutions if the beneficiary is at least a half-time student.
• Income Limit: While 529 plans do not have an income limit, Coverdells allow families members to contribute up to $2,000 if their modified adjusted gross income (AGI) is less than $95,000 per individual and $190,00 per joint filing couple. While less than $2,000 can be contributed for income levels going up to $110,000 per individual and $220,000 per joint filing couple, contributions cannot be made into the account for those earning over that amount of $110,000 per individual and $220,000 per joint filing.
• Age Restrictions: While there are not any age restrictions on 529 college savings accounts, Coverdells allow families to make contributions into an account for a beneficiary up until they turn 18 years old. Additionally, Coverdells require assets to be distributed within 30 days of the earlier of the beneficiary turning 30 years old or death. One option is to have the assets rolled over to another family member’s Coverdell account if they are less than 30 years old, or to roll the assets over to a 529 plan.
• Contribution Limits: 529s allow investors to contribute up to the annual gift taxing limit of $14,000 per year per account-owner beneficiary relationship, or $28,000 per joint filing married couple. Additionally, 529s allow an accountowner to make five years of gifting in one year such as $70,000 per single filer or $140,000 per join filing married couple. In contrast, Coverdells allow contributions up to a total of $2,000 per beneficiary per year. While the beneficiary may have multiple Coverdell accounts, the contributions into the various accounts from multiple family members cannot exceed $2,000 in one year.
• Market Risk: While a 529 prepaid plan locks in tuition prices and specified fees at eligible colleges, assets in a 529 savings plan are invested in a menu of investment options offered by the state in its plan disclosure statement and selected by the investor.  Coverdells are typically more akin to 529 savings plans as investors are able to self-direct their investment selection among a set of offerings by product providers which typically include those that are exposed to market risk. Coverdell product providers can offer many different types of investment options, except for life insurance products.
• Investment Changes: Coverdells allow for unlimited investment changes per year, while 529s are granted two investment changes per year.
• Account Control: 529s allow the accountowner to maintain control of the account, and allow for an unlimited number of rollovers if the beneficiary is changed to a member of the family of the previous beneficiary. Therefore, 529s allow changes in beneficiaries while the accountowner maintains control of the account. In contrast, the beneficiary’s parent or guardian maintains control of the Coverdell account until the beneficiary is no longer a minor, and the control of the account may change at that time depending on the terms of the account. Additionally, the assets in the Coverdell can be rolled over to another family member that is less than 30 years old, or rolled over to a 529 plan.
• Distribution Restrictions: 529s allow distributions to the school, accountowner or beneficiary. Coverdells allow distributions to the school or beneficiary, and therefore does not allow distributions to the donor.
• Non-Qualified Distributions: For both 529s and Coverdells, the earnings portion of a non-qualified 529 distribution is subject to federal and any applicable state or local tax, in addition to a 10% federal penalty.

Therefore, advisors, accountants and estate planners should understand the key product features of 529s and Coverdells, how the two types of plans function independently and ensure the most appropriate investment vehicle is used for your clients given their specific needs

Next week, we will compare and contrast 529 savings plans and Trusts (UGMA/UTMA).