How to Save for Your Kid’s College Through Coverdell ESA and 529 Plans

As a physician, you know the value of a good education. You also know how much that costs.

Crafting a college savings strategy is a Herculean task, but it can be made easier by federal- and state-provisioned education investment accounts. The two most popular education savings plans are Coverdell Education Savings Accounts (ESAs) and 529 plans. Here we will examine these two plans’ benefits, limitations, and other key details.

Coverdell ESAs and 529 Plans: Tax-Advantaged Accounts for Education

Both Coverdell ESAs and 529 plans are tax-advantaged investment accounts that parents (or uncles and aunts — anyone, really) can use to save for education: elementary, secondary, and college. You can open both Coverdell ESAs and 529 plans at a brokerage firm like Charles Schwab or TD Ameritrade.

Coverdell ESAs and 529 plans provide tax-free growth on contributions and tax-free withdrawals, similar to a Roth retirement account.

Here’s a scenario to illustrate the impact:

• Scenario 1: You contribute $2,000 to a taxable brokerage account and invest the entire sum in an S&P 500 index fund that pays you $100 in dividends in each of Years 1–5. You’ll include $100 in dividend income on your tax return during each of these five years. Then, at the end of Year 5, you withdraw the investment at $4,500, triggering a capital gain tax of $2,500 ($4,500 value at time of sale – $2,000 original investment – $500 reinvested dividends) in Year 5.
• Scenario 2: You contribute the $2,000 to a Coverdell ESA or 529 education investment account instead of a taxable brokerage account. Although you earn $100 in dividends from Years 1–5, you won’t be required to pay income tax on it. Then, in Year 5, when you withdraw the investment at a value of $4,500, you won’t be required to pay income tax on the capital gain as long as you use the entire amount to cover qualified education expenses.
• Conclusion: Contributing to a Coverdell ESA or 529 education investment account is a wise choice as you have the potential to avoid capital gain taxes you would from standard brokerage accounts.

Benefits of Educational Investment Accounts for Financial Aid

Both 529 and Coverdell ESA investment accounts make it easier to qualify for financial aid compared to saving for education using a taxable brokerage account. Financial aid is mostly allocated by how much an applicant/applicant’s family holds in assets.

When filling out the Free Application for Federal Student Aid (FAFSA), which most colleges use to determine a family’s need for financial aid, a relatively small portion of these accounts’ values are counted toward the total financial portrait a student presents. Compare that to a taxable brokerage account, where 100% of the funds are counted.

Note: penalties apply when you withdraw funds and don’t use them on qualified education expenses within the same year. But there are exceptions — such as when your child receives a qualified scholarship — to getting the money out penalty-free.

What is a Coverdell ESA? Key Features and Benefits

Coverdell ESAs are custodial investment accounts — more on what that means below— whose funds can be used to pay for qualified elementary school, high school, or college expenses.

Coverdell ESA Benefits

• Provides tax-free growth and withdrawals when funds are used for qualified education expenses.
• Allows funds to be used to pay many types of elementary, secondary, or college expenses, including tuition.
• Lets you change the beneficiary to another person in the initial beneficiary’s family.

Coverdell ESA Limitations

• Allows contributions only from individuals whose MAGI (modified adjusted gross income) is below $110,000 per year ($220,000 for married filers), although workarounds exist.
• Limits contributions to $2,000 per year per beneficiary (not per account).
• Doesn’t allow contributions once the beneficiary turns 18 years old (unless the beneficiary is a “special needs beneficiary”)
• Requires full account distribution by the time the beneficiary reaches 30 years old (unless the beneficiary is a “special needs beneficiary”)

ESA Accounts Are Custodial

This is an important consideration. It means that their funds are legally owned by the beneficiary, so as the parent/relative contributing to your child’s education, you legally lose control of your child’s education savings.

Once the beneficiary reaches the age of majority (which depends on your state), it could be theirs to decide how the funds are used. Of course, the funds must still be used to cover qualified education expenses to avoid taxation.

Example: You have two children, and there are leftover funds in your older child’s ESA. Unless your older child agrees, or you switch the beneficiary before the first child reaches the age of majority, the custodial nature of ESAs could prevent you from using leftover funds to pay for your other child’s education expenses. Depending on your perspective, this can be a con or a neutral point.

Why Physicians Might Shy Away From ESAs

• The per-beneficiary annual contribution limit is only $2,000, which may not be enough to make a dent in the tremendous cost of education today.
• You can only contribute to a Coverdell ESA in years when your modified adjusted gross income (MAGI) is less than $110,000 (if you’re a single filer) or $220,000 (if you’re married filing jointly).

Although there are ways around the income restrictions — by gifting the money to your child and having them contribute to the ESA themselves — it may not be worth the hassle, particularly because there are other savings vehicles, like 529 plans, out there.

Understanding 529 Plans: Advantages and Limitations

A 529 plan, also called a qualified tuition plan, is a state-administered investment account that allows similar tax benefits to Coverdell ESAs. Unlike ESAs, there are generally no contribution limitations based on an individual’s income.

• Annual contribution limits vary by state, but they’re generally significantly higher — typically around $300,000 — than the Coverdell ESA limit of $2,000 per beneficiary. 529 plan funds can only be used on a list of qualified education expenses, which differs slightly from the list for Coverdell ESAs.
• 529 plans are mostly geared toward college savers. Still, up to $10,000 per year can be distributed from the account to fund qualified elementary or high school expenses.
• There’s no age limit by which 529 plan funds must be distributed, and contributions can also be made at any time, regardless of the beneficiary’s age.

Advantage of 529 Plans: They Can Be Custodial or Non-Custodial

Some 529 plans are custodial (meaning the beneficiary owns the funds), and some are not (meaning the parent owns the funds). From a financial aid perspective, it’s better when the account is parent-owned: Only 5.64% of the assets in parent-owned 529 plan funds are considered for FAFSA. By contrast, 20% of the assets in dependent-owned 529 plan funds are considered for FAFSA. When more assets are considered, it can look like you have a great ability to self-fund your child’s education, potentially negatively impacting financial aid eligibility.

Many states allow you to choose between a parent-owned or custodial 529 account. Recent tax law changes made 529 plans even more attractive:

• Beneficiaries can use up to $10,000 (the lifetime limit) of 529 plan funds to repay student loans.
• Apprenticeship costs may be eligible as a qualified education expense.
• 529 plans held by grandparents aren’t considered for FAFSA.
• Leftover 529 funds can be rolled over into a Roth IRA without penalty.

529 Plan Benefits for Physicians

• Provides tax-free growth and withdrawals when funds are used for qualified education expenses.
• Lets you change the beneficiary to another person in the initial beneficiary’s family.
• Doesn’t impose income limitations on plan contributors.
• Allows contributions at any time, regardless of the beneficiary’s age.
• Provides high annual contribution limits that vary by state.
• Allows beneficiaries to use up to $10,000 in a lifetime to repay student loans.

529 Plan Limitations for Physicians

• Limits qualified education expenses to $10,000 per year for elementary and high school expenses.
• Often provides limited investment choices.

Coverdell ESA vs. 529: Which Is Better?

It’s smart to use one or both of these accounts to save and pay for your child’s elementary, secondary, or college education. You get a heap of tax benefits that can help you funnel more of your hard-earned money into costly education. Plus, saving in these accounts makes it easier to qualify for financial aid.

The best plan for you depends on your financial situation and what you’re saving for. However, for physicians with high incomes, a 529 plan is likely the more practical savings vehicle, especially if your focus is on saving for college rather than elementary or high school.

Consult a financial advisor to learn more about the contours of each plan and the specifics of 529 plans in your state.

Join the Discussion

Have you contributed to a Coverdell ESA or 529? What has your experience been and what questions do you have about saving and paying for education? Let us know in the comments below!