In just about any publication you read, from newspapers to magazines, "experts" are hailing the unmatched benefits afforded to you for education savings through a 529 Savings Plan. From the possibility of state tax deductible contributions, to high contribution limits, to tax-free distributions, the 529 Savings Plan turns water into wine. Most "experts" would not only have you believe that these accounts are the end all, be all of education savings vehicles, but that you have some form of neurological malfunction if you haven't already established one of these plans!
I absolutely agree that the 529 Savings Plan is an outstanding means of savings for future education costs, and recent tax law changes have only furthered their appeal. I will readily admit that in our financial planning practice, virtually all of our clients with young children have some funds directed towards a 529 Savings Plan, and I have been funding a 529 Savings Plan for my daughter since her birth two years ago. Having said this, however, I will emphatically declare that the Coverdell ESA is a wiser choice, in most cases, and should be fully funded before you dedicate any monies to a 529 Savings Plan.
Now that I have committed some form of education savings planning heresy, let's understand the fundamental differences between these accounts. Both are used for education expenses, and the range of "qualified withdrawals" from a Coverdell ESA is virtually identical to 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. Whereas, "qualified expenses" for a 529 Savings Plan are for use at a qualified higher education institution only. If your purpose is to save for college (or equivalent higher education), then perhaps the difference between these definitions for qualified expenses does not matter much to you.
The 529 Savings plan does offer 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. The 529 Savings Plan contribution limits vary from one plan to another, but ranges from $100,000 to $305,000. A grantor can use up 5 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 you or your clients choose to perform such an action.)
The most dramatic appeal of the 529 Savings Plan has always been the account owner's ability to control the funds. Despite the gifts to an intended 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." Fundamentally, our clients have always appreciated this feature, and the 529 Savings Plans have grown in popularity over the more conventional UGMA custodial accounts just a few years ago. 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 the ability of a sweet babe turned devil-child to take the money and run when they turn 18. (Of course, both accounts do offer the option of assigning the funds to an alternative beneficiary.)
One additional difference that continues to defeat my assertion that the 529 Savings Plan isn't the almighty lord of the education savings arena is the potential tax deductibility of contributions. There is no deduction for contributions to a Coverdell ESA - $0, nothing. Some states allow deductions for contributions to their respective 529 plans. Remember 529 Savings plans are administered by the states, and each has its own rules and regulations. As an example, New York will offer up to a $5,000 state income tax deduction for contributions to the New York State plan. This only applies to New York State residents. In my great state of New Jersey, there are no available deductions for contributions to the state's plan. Each state is different, and careful consideration should be given to whose plan you use relative to where you live.
Now that I am seem to have proven myself wrong, allow me the opportunity to prove that I am not. (Since I tell my wife that I've never wrong, why should this be any different?) 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...at least for now. The tax-free nature of distributions from 529 Savings Plans was instituted as part of the EGRTTA of 2001, which sunsets in 2010. Therefore, barring congressional intervention, qualified withdrawals from a 529 Savings Plan in 2011 and beyond will be considered income to the beneficiary. This is a HUGE difference. Will Congress intervene? Political aficionados would argue that senators and congressmen cannot afford to not intervene, but as planners and advisors, you?ve got to work within the framework that you are provided. If your client's children aren't going to complete school prior to 2011, you?ve got a potential tax situation.
O.K. - you'd bet the farm that Congress will act. After all, they?re not going to sit idly by and watch millions of their constituents get slammed with income tax bills that they didn't anticipate and potentially jeopardize the education plans of America's sons and daughters. Well, Congress might...and so may the states. Currently, states are not taxing distributions from 529 Savings Plans, but indications are that this is changing. Several states are considering applying 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 reserves the right to tax your client's withdrawals. With states facing greater and greater budget crisis (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.
Some clients may take the position that the control offered by a 529 Savings Plan is worth the potential tax costs versus a Coverdell ESA. Having some clients of my own whose grasp on their money is vice-like, I can understand and appreciate this stance. So, let me offer you one more swift kick in the groin to prove my point. As states are the administrators of their respective 529 Savings Plans, the assets in these plans belong to the state's plan, not the fund company who manages them. Let's be very clear on this issue: if you are using a plan offered by New York, for example, those assets are part of the New York 529 Savings Plan, not the mutual fund sponsor whose name may appear on your client's statement. 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. The contracts will eventually come up for renewal. This is a major wake up call in light of the mutual fund trading scandals engulfing the industry right now. Would a mutual fund company who is the front-page embodiment of all that is evil in the financial world get their contract renewed today?
In order not to single out a particular firm, I will avoid the use of specific examples, but this general illustration should suffice. Let's say that you are using State X's plan and it is being managed by Fund Company A. If State X terminates Fund Company A's contract at its renewal and brings in Fund Company B, your client's assets don't stay with Fund Company A. After all, those assets "belong" to the state! Not such a big deal, unless your client is in class B shares with a contingent deferred sales charge. Holy Unexpected Charges Batman! What does your client do now? The answer is that no one knows, since it hasn't happened yet. Will Fund Company A simply waive the CDSC, or will they want to get the last bit of compensation available to them after losing possibly $100 million in assets under management. Despite the unforeseen contract termination, and your client's downright bad luck, they knew the risk that these contracts presented them with, didn't they? Didn't you?
Hopefully the industry's image will continue to improve from here. Perhaps even the most tarnished of reputations will shine brightly once again. Maybe states will never terminate any in-force contracts and your client's assets will remain unfettered. What is important to understand, what is imperative that you communicate to your clients, is that these possibilities exist. These risks exist, and they are as real as the risks associated with equity investments. It is your obligation to explain any and all risks associated with an investment to your client, even if it is different from the market risks you are accustomed to conveying.
Finally, let's examine the practical use of the Coverdell ESA and 529 Savings Plan in everyday client application. A typical example of a client who will come to our firm to begin the college planning process has a child 2 years old and no current education oriented savings. They indicate that they want to fund a full 4-year education at a "good" school, not necessarily the most expensive of the Ivy League, but a highly regarded private university - one that currently costs around $30,000 per year. Assuming that college costs will continue to inflate at 6% per year, and that your client's funds will grow at 8% per year, they need 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) next.
The honest truth is that both plans are attractive education savings vehicles, and that you would likely not go wrong by steering clients into either or both accounts. There are advantages to each plan over the other, depending on each client's specific set of circumstances and objectives. Please recognize that there exists very specific and unique risks associated with 529 Savings Plans, both under current tax law and in regards to their state administered nature. In our ever increasing litigious society, please do not neglect to discuss these risks with your clients and help them make the decisions most suitable for they and their families.