If personal finance were an orchestra, there would be little doubt what would occupy the first chair in the College Savings section.
The 529 savings plan has for years been the darling of investors and advisors, and there are good reasons for its popularity.
However, I assert that the Coverdell Education Savings Account is more deserving of top billing, even if it lacks some of the panache of the 529.
Before you write this article off as pure heresy, please understand that this is not a dismissal of the 529 plan. The 529 is, by most measures, an outstanding means of savings for future education costs, and recent tax law changes have only improved its appeal. I will readily admit that in my firm's financial planning practice, virtually all of our clients with young children have some funds directed towards a 529, and I myself have been funding one for my daughter since her birth two years ago.
This said, I emphatically declare that in most cases the Coverdell ESA is a wiser choice, and that such accounts should be fully funded before an investor dedicates any funds to a 529.
What's the Difference?
With that little bit of heresy out of the way, let's understand the fundamental differences between these accounts. Both are used for education expenses, but the range of “qualified withdrawals” from a Coverdell ESA is wider than that of a 529 Savings Plan.
A “qualified expense” for a Coverdell ESA is defined as tuition, room, board, fees, supplies and special needs related to the attendance of a qualified elementary, secondary or post-secondary institution. In essence, if it's a school related expense (be it high school, college or whatever), it will likely be covered.
By contrast, “qualified expenses” for a 529 are defined as tuition, room and board at an institution of higher education. You would not be able to use 529 plan distributions to pay for books, notepads, pens, etc. — expenses that over a four-year education can amount to several thousands of dollars.
True, if an investor's purpose is to save specifically for college (or equivalent higher education), then perhaps the difference between qualified expenses does not matter much.
Further, it's true that a 529 plan offers the grantor/contributor far greater means of funding the account. Coverdell ESA contributions are limited to $2,000 per year. There are income phase-out limitations for contributions; however, these are easily bypassed by gifting funds directly to the beneficiary and allowing them to fund the Coverdell ESA. Meanwhile, the 529 contribution-limits vary from one plan to another, but range from $100,000 to $305,000. A grantor can use up to five years of annual gift exclusions in one motion and contribute $55,000 to a plan. (There are additional tax implications in the event of the grantor's death, which need to be examined if your clients choose to perform such an action.)
But by far the most dramatic appeal of the 529 Savings Plan has always been the account owner's ability to control the funds. Even after gifting funds to a beneficiary, the account owner maintains absolute control over the funds and can reclaim them should the intended beneficiary turn out to be a “bad apple.”
The Coverdell ESA does not offer such control. The beneficiary obtains control of the funds upon reaching the age of majority (18 in most states), and the funds must be distributed by age 30. In this regard, the 529 Savings Plan offers greater flexibility and a degree of insurance against a sweet-babe-turned-devil-child taking the money and running when he turns 18. (Of course, both accounts do offer the option of assigning the funds to an alternative beneficiary.)
One additional difference that argues against my assertion about the Coverdell's superiority is the potential tax-deductibility of contributions. There is no deduction for contributions to a Coverdell ESA — $0, zip, nothing — but some states allow deductions for contributions to their respective 529 plans. For example, New York will offer up to a $5,000 state income tax deduction for contributions to its plan.
The Case for Coverdell
For all the benefits of 529s, Coverdells have more to offer. For starters, withdrawals from a Coverdell ESA are tax-free, providing that they are used for qualified expenses. Withdrawals from a 529 Savings Plan are federally tax-free, providing that they are also used for qualified expenses, but, as discussed above, the definition of “qualified” is tighter, and the federal guidelines are subject to change. The tax-free nature of distributions from 529 Savings Plans was instituted as part of the tax code changes of 2001, which sunsets in 2010. Barring regulatory intervention, qualified withdrawals from a 529 Savings Plan in 2011 and beyond will be considered income to the beneficiary, a huge difference.
True, many believe Congress will intervene to change this situation. But as planners and advisors, we've got to work within the framework provided. If your client's children aren't going to complete school prior to 2011, a 529 account spells a potential tax situation.
For argument's sake, let's assume Congress will pass legislation to head off that tax bill. There are still state taxes to be considered. Currently, states do not tax 529 distributions, but several states are considering instituting a state income tax for distributions from out-of-state plans. For example, if your client lives in New Jersey, but has been funding a plan in Ohio, New Jersey might reserve the right to tax your client's withdrawals.
With states facing greater and greater budget crises (New Jersey's projected 2005 budget deficit exceeds $4 billion), this possibility seems more a question of “when” than “if.” States need money, and this is certainly one place to get it.
On another front, some clients may take the position that the control offered by a 529 is worth the potential tax cost. But there is at least one specific way that 529s could cause customers to lose control of the way their money is invested.
Since states are the administrators of their respective 529 Savings Plans, the assets in these plans belong to the state's plan, not to the fund company who manages them. Why does this matter? Because fund companies have contracts in place to operate these plans on behalf of a state for a specific period of time — contracts that will eventually come up for renewal. Let's say a particular state decides that it doesn't want to renew a mutual fund's contract — perhaps the fund ended up on the wrong side of a Wall Street Journal exposé.
When the state terminates the contract, that means your client's assets will be moving to another fund. Not such a big deal, unless your client is in class B shares with a contingent deferred sales charge. Then it's “Holy Unexpected Charges, Batman!”
What does your client do now? The answer, of course, is that no one knows, since it hasn't happened yet. Will the cancelled fund company simply waive the charge, or will it want try to squeeze out the last bit of compensation available after losing $100 million in assets?
The End Game
What is important to understand — in fact, what is imperative that advisors communicate to their clients — is that these risks exist, and they are as real as the risks associated with equity investments. It is the advisor's obligation to explain any and all risks associated with an investment, even if it is different from the market risks they are accustomed to conveying.
So what to do in light of this information? Let's take a client who is beginning the college planning process. He has a two-year-old child, and no current education-oriented savings. The client indicates that he wants to fund a four-year education at a “good” school — not necessarily Ivy League — but a highly regarded private university currently costing $30,000 per year.
Assuming college costs will continue to inflate at 6 percent per year and that the client's funds will grow at 8 percent, the client needs to save approximately $850 per month ($10,200 per year) for the next 16 years.
In most circumstances, the wisest course of action would be to fully fund a Coverdell ESA ($2,000) and then fund a 529 Savings Plan ($8,200 more) after that.
The honest truth is that both plans are attractive education savings vehicles, and that few advisors would go wrong steering clients into either or both accounts.
But it's important to note that there are specific tax and control issues associated with 529 savings plans. And given the current climate of our industry, addressing these risks with clients up front to help them make the most suitable decisions is a must.
Writer's BIO:
Michael F. Greco is a partner in GCI Financial Group, a financial planning agency located in Maplewood, N.J. He can be reached at 866-493-7700.
