IT'S ALL ABOUT MONEY
A comparison of Section 529 plans and Coverdell Education Savings Accounts
By William A. Clemmer and Gary S. Lesser, Esq.
Sorting through various types of college savings plans is certain to result in a pile of paper or a large file. Discovering what works can be a daunting task and subjects one to sorting through that pile. And of course, each client is different. So while there are many similarities in the plans offered, a listing of differences between Section 529 and the Coverdell Education Savings Account (CESA) should be helpful in determining which plan to use for an individual client.
Sunset provision: Remember that at this point most EGTTRA provisions expire in 2011. While most feel that EGTTRA will be extended, we must recognize the possibility that it may not be. The term "sunset" refers to that.
Availability
Most states have 529 plans (all soon will). CESA is available in every state. State 529 plans are generally run by third parties (investment companies) under the auspices of the state treasurer's office. So each plan tends to be different, often dramatically so. The state income tax treatment of CESA and 529 are the same (except "sunset"). But remember to ask all of the other questions, such as:
1. What is the possibility of using the funds for a private high school? Use CESA.
2. Do you or can you contribute more than $2,000 per child per year? Think 529.
Differences between 529 and CESA
1. Use: Both 529 and CESA can be used to pay for college, graduate, and professional education with qualified institutions. In addition, CESA can be used to pay for K-12 education-related expenses such as software, Internet access and lab fees.
2. Annual Contribution Limits: CESA--$2,000 per year with no overall lifetime limits. 529 plans--Each state plan sets limits of contributions and lifetime account balances in accordance with Internal Revenue Code regulations and state regulations.
3. Tax Treatment: There is no federal deduction for contributions for either plan. CESA withdrawals are federally tax-free for qualified expenses. 529 withdrawals are federally tax-free for qualified expenses until 2011 ("sunset") at which time they will be taxed at the beneficiary's rate (if not extended). While some states allow contributions to 529 plans to be deductible, none do so for CESA.
4. Eligibility: Currently, anyone can open a 529 plan regardless of income. On the other hand, contributions to CESAs are limited to households with lower-than-threshold income. It has been suggested that a legal way around this is to gift a trusted friend or relative with lower income. That person would then contribute to a CESA with your child as a beneficiary.
5. Age Restrictions for Beneficiaries: 529s have none. CESA does not generally allow contributions for beneficiaries over 18, and withdrawal beneficiaries generally must be under 30.
6. Investment Flexibility: CESAs may be opened with most mutual funds, banks or other financial institutions. 529 plans are generally restricted to the sponsoring organization (See state plans--under "Availability"). So investment control is greater with a CESA. On the other hand, a 529 may offer autopilot rebalancing as children move toward college.
7. Investment Control: The owner manages CESAs. The sponsor (investment company) manages the 529 plans with input (supervision) from the state (program manager).
8. Uniformity: CESA rules are nationally uniform under federal law. 529 plan rules differ in each state.
9. Creditor Protections (and ex-spouses): CESAs appear to allow more protection. 529 rules differ in every state. Check with your legal or financial advisor.
10. Financial Aid: Currently, CESA plans are considered a student's assets. A 529 is considered the parents' assets and thus less harmful from a financial aid standpoint. A 529 "pre-paid" plan may reduce the amount of financial aid dollar-for-dollar. Distributions from both 529s and CESAs are considered the student's income and thus may affect financial aid. It may be a good idea to run EFC (Expected Family Contribution) calculations for families with children entering their teens. This may be a good time to start thinking about financial aid.
The amount of financial aid available may be affected by funds in a 529 plan. This is reflected by the interaction of saving (ability to pay) and eligibility. A student's financial aid need is determined by the difference between the cost of attendance (qualified expenses, as noted elsewhere) and the student's EFC (or the amount that the student and family are expected to contribute toward college costs). Thus, for any cost of attendance, the larger the EFC, the lower the financial aid eligibility.
11. Tax Treatment: 529 plan contributions are not deductible for federal income tax purposes. However, earnings on these contributions are tax-free until withdrawal. Qualified withdrawals are free of federal income tax (under EGTRRA). States that currently do not exempt earnings from state income tax are expected to follow suit.
Roth IRA--Another Consideration
1. 529 plans are limited to qualified expenses, varying (by state) contribution levels, sponsor investment portfolios and decisions, taxes and fees on non-qualified distributions. Roth IRAs have none of these.
2. For many families, college expenses are another--albeit major expense; so the flexibility of source, control, investment use and timing of its use may be important.
3. You may recommend some of each. As an example, use a Roth IRA if:
a) Both parents have good retirement plans and plan to continue contributions at an increasing rate;
b) At least one parent is in his or her mid-40s. When the child(ren) are in college and that parent reaches age 59 1/2, withdrawals are tax-free. This is the same for both CESA and 529 plans.
The advantage of a Roth IRA is that the owner has complete control over the use of the funds. If the children don't go to college, qualify for financial aid, don't need the entire amount, then the parents have the use of the funds.
Fees
Read the prospectus carefully. Look for fees by whatever name: initial, ongoing or maintenance, transfer, withdrawal, internal (described as or in "expense ratios"). Fees are an issue in the absence of value. Higher fees do not equate to higher returns; however, neither do lower fees. Pick the lowest fee plan with the investment objective that fits the goals of your client.
"Mini 401(k)"
For the self-employed, consider a Mini 401(k). They can provide great benefits, including sizable tax deductions, (especially with employed spouse), tax deferral and loan provisions. With proper planning, a Mini 401(k) can be a great addition or alternative.
Multiple Plans
There is no reason for not having multiple plans. So it may be wise to utilize all avenues--retirement plans (maximize them), Roth IRA, 529 plans, savings accounts, UTMA/UGMA and even savings bonds. There are an increasing number of Web sites sponsored by investment companies (e.g., Fidelity, TIAA-CREF) and financial magazines (e.g., money.com, smartmoney.com) and others (e.g., fairmark.com, savingforcollege.com) that provide summaries and charts comparing various options.
Picking the Right Plan
No two plans, two clients, or even two children of the same clients are alike. The 20 or so considerations and the dollars involved suggest professional assistance. Each state has negotiated its 529 plan with an investment sponsors(s). The short track records of 529 investments are a concern. However, CESAs use existing investment vehicles. So, consider the manager, not a performer.
Total costs (by whatever name) vary--from less than 0.3% to more than 2%. Look for hidden costs and extra fees. The lower the total costs, the more of the contribution is working for your client.
With limited investment choices, look for better investments, not the plan with the most. 529 plans limit transfers; however, even CESAs, if they follow the pattern of their IRA siblings, will not be moved a great deal. So it's important to use good managers. The age-based portfolios offered by many 529 plans (and a growing number of investment companies) might be a wise choice (and planned investment discipline). "People forget that they usually have fewer years to save for college than for retirement--most often 10 years or less," notes TIAA-CREF Vice President Timothy Lane. "If you lose a lot in the early years, it's hard to make it up."
Planning for college financing can be complicated. But tools are available. And the absolutely best time to get started in any savings plan is when the market is low. *
The authors
William A. Clemmer and Gary S. Lesser, JD, head up Financial Services Agency Consulting (FSAC), a division of The Rough Notes Company.