College Savings Plans: Funding a 529 or Coverdell?

College saving is on the rise. Nearly 75% of parents are now saving for college, compared to just half in 2007, according to Fidelity Investment’s College Savings Indicator Study. This is a positive trend, but it is important to save in an efficient way. According to a 2015 study by Sallie Mae, about half of the parents who do save use a bank savings account.

While having some savings is better than nothing, using a savings account is actually the least effective way to grow college funds (other than not saving at all). As of this writing, the going rate for an online high-yield savings account is about 1%. For a traditional savings account at your local bank, the national average is a paltry 0.08%. Think about that in the context of the lost opportunity to benefit from compound interest. (For more, see: Using 529 Plans to Save for College.)

With such a drastic difference in growth potential, clearly an investment account with access to stocks is preferable to a savings account. While it is not possible to predict market returns with any level of certainty, we can look to the past for an estimate. Vanguard research shows that a balanced portfolio of 60% stocks and 40% bonds (a typical allocation in many college savings 529 plans) had average annual returns of 7.8% from 1926-2015.

Granted, some years were higher than 7.8% in that time period, some were lower. And unfortunately, no one has a crystal ball to figure out which will be good years or bad in the future. But just to put that 7.8% return in perspective: if you had saved $200 per month starting at the child’s birth, even with no annual increases, those savings would snowball to $95,026 by the time the child was 18, thanks to the power of compound growth.

Tax-Deferred College Savings Plans

You have two options when it comes to tax-free college savings plans: a 529 plan or a Coverdell Education Savings Account (ESA).

In almost all cases, I recommend 529 plans over Coverdell ESA plans (though, as with any financial planning, it does depend on your individual situation). The contribution limits for a 529 plan are much higher than an ESA, and there is no income restriction. ESA accounts are restricted to families with gross income under $220,000 a year and annual contributions are limited to a maximum of $2,000 per year until the beneficiary's 18th birthday. Unfortunately, even at current levels of in-state college tuition, that level of savings is not likely to meet the full cost of college. (For more, see: Student Loan Debt: What Every Borrower Should Know.)

Both ESAs and 529 plans have tax-free distributions for qualified expenses; however, many states allow a state tax deduction for their residents who participate in the state sponsored 529 plan.

There is also a tremendous amount of flexibility with unused 529 plan funds. Certain state plans allow for an indefinite time frame for an account to remain open. In addition, accounts can be transferred between qualified family members (first cousins, siblings, offspring). In contrast, ESA accounts must be used by the time the beneficiary is 30.

529 plans can be used to fund a broader range of post-graduate programs (including qualified continuing education and certificate programs in addition to qualified colleges and graduate schools), while ESAs can only be used for qualified K-12 programs, college and graduate school.

Which 529 Plan is Best?

You have a lot of choice when it comes to 529 plans, but I recommend always looking at your state plan first. You may receive a state tax deduction for 529 plan contributions. But be cognizant of the cost versus benefit of any plan. If you are paying steep fees or commissions to invest in your state 529 plans, the tax benefit may not outweigh that cost, so it would be better to find a lower-cost plan in another state. Savingforcollege.com has a good comparison tool that lets you view features of various state plans. If your own state does not offer tax deductions for 529 plan contributions, you can select a high-rated plan from anywhere in the country. (For more, see: 5 Financial Tips for New Parents to Cut Costs.)

 

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