The first option available is a Coverdell ESA. The contributions to this particular type of account accrue with tax deferrals as well as tax-free distribution should you utilize it as a qualified education expense. Overall, the main benefits of these accounts include the broad range of investments offered in comparison to 529 plans as well as the fact that they can be used for qualified elementary, high school and college expenses.
At the same time, Coverdell ESA’s come with a number of potential drawbacks. For one thing, you can only contribute $2,000 a year per child. For another, an income limit phases out contributions for married couples that file jointly and maintain an income over $220,000.
Another option — or rather, an additional option because one can utilize both — is a 529 plan. By definition, the 529 plan has a much higher contribution limit, no income limit and maintains estate planning benefits as well. Specifically, a parent or more typically, a grandparent or great grandparent, can contribute 5 years of gifting in one year. Although they will not be able to offer gifts to that grandchild, without using lifetime gift tax exclusion or paying gift taxes, for another 5 years afterwards, the 529 allows the money to be removed from the donor’s estate and to grow outside of it. A further benefit is that the donor still has control over how the money is used while they are alive — despite the fact that it is considered “removed” from the donor’s estate.
Alternatively, one can also use contributions to a Roth IRA. As long as you restrict your use to the contributions to your Roth IRA and not the earnings, you won’t have to pay taxes on the withdrawal. The main advantage of this approach is that if you end up not needing the money for college expenses, the money continues to grow tax free, without penalty.
At the same time, using a Roth comes with a major problem that prohibits me from recommending it as a first choice. Specifically, it reduces the amount you are saving for retirement in a tax advantaged account. As one expert notes, your child can borrow for college, but you can’t borrow for retirement.
The further option for education planning is a Custodial account. For a custodial account, each year you can gift money into the account ($13,000 or $26,000 if you and your spouse gift). The main benefits are that up to $950 of the earnings may be tax free and the next $950 of earnings is taxed at the child’s presumably lower tax rate. However, the money belongs to the child, and once he reaches maturity (18 or if designated, 21) the money is his. Furthermore, a custodial account may incite negative consequences when trying to secure financial aid, because financial aid formulas typically target a great percentage of a child’s assets than the parents.
There is much more to be said regarding education planning, since each individual’s situation is unique. However, 529 plans are typically the primary option I recommend. However, for some parents starting earlier and below the income limits, adding a Coverdell account may be beneficial when planning on sending their child to a qualified private elementary or high school.
Eitan Tashman, MBA, Chartered Retirement Planning CounselorSM
Eitan is a fee-only financial planner and investment advisor and can be reached at firstname.lastname@example.org or 323-782-9600 ext. 17
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