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Which Account Should I Choose?

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By Robert Brokamp

It's time to take the final for your college savings course. If you've stayed awake in class, then you know about the best places to stick your college funds: the Coverdell Education Savings Account, the 529 prepaid tuition plan, and the 529 college savings plan. But which is right for you?

Lucky for you, this is a multiple-choice test. First, to compare all the features of these plans side by side, review our handy-dandy, info-licious College Savings Plans Comparison Table.

The first question you need to answer is whether you should enroll in a prepaid tuition plan. Here are the main considerations:

Why a prepaid tuition plan is right for you:

  • You're risk-averse.
  • You like knowing your tuition will be covered.
  • You don't think you'll be eligible for financial aid. Unlike the other options, assets in a prepaid tuition plan reduce financial aid eligibility dollar-for-dollar. (See The Financial Aid Factor .)

Why a prepaid tuition plan is wrong for you:

  • A prepaid plan is not offered by your state or by the school your child wants to attend.
  • You prefer to choose your own investments.
  • Your children are young, so the longer time horizon will allow you to be more aggressive with your investments, potentially resulting in more money.

If you'd rather use an investment account to fund your or your progeny's college education, then you have another choice to make: Should you choose a Coverdell ESA or a 529 savings plan? Here are the most important considerations:

Why a Coverdell ESA is preferable:

  • Distributions are tax-free. So are distributions from a 529 plan -- until 2011. It's likely that Congress will extend the tax-free treatment of distributions, but it's not a sure thing.
  • You choose the investments. You can invest in the stocks, bonds, mutual funds, or just plain old cash. With a 529 plan, you must choose a money manager. On top of that, since most 529 plans are relatively new, these accounts have short histories, making it difficult to evaluate their quality.
  • Funds in a Coverdell ESA can also be used for eligible primary- and secondary-education expenses.

Why a 529 savings plan is preferable:

  • The control over the funds in the 529 will always reside with the contributor. This is not true with a Coverdell ESA, since it is a custodian account. Assets in a Coverdell ESA become the property of the beneficiary at age 18, and he or she can use the money for a diploma or at Williams-Sonoma.
  • The contribution limits to 529 plans are significantly higher.
  • Assets in a Coverdell ESA are considered property of the student, which can reduce the student's financial-aid package. On the other hand, the assets in a 529 savings plan belong to the account owner.
  • Your state may offer a tax deduction for contributions to the local 529 plan. (Curious if your state does? Check out the State Tax Treatment of Qualified State Tuition Programs chart from the College Savings Plans Network website.) Also, some states offer other perks, such as scholarships and matching contributions.

The good news
Thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, investors can simultaneously contribute to a Coverdell ESA and both types of 529s. Why would you do this? Here are a few scenarios:

  • You want to diversify. You want some of your money to lock in a portion of future tuition costs through a prepaid plan, but you also want to see if your investing prowess can provide a better return.
  • You've decided to enroll in a prepaid tuition plan, but you'd also like to save for room and board (which aren't covered by some prepaid tuition plans).
  • You want to get the state tax deduction by investing in your state's program, but you don't want all your college savings in the hands of money managers, so you open a Coverdell ESA and make your own investment decisions.
  • Your kids will go to college after 2010, and you don't want to risk Congress not extending the tax-free status of 529 withdrawals. So, you put the first $2,000 in a Coverdell ESA, then put the rest in a 529 plan.
  • You anticipate that your child will attend private elementary and/or secondary schools, so you contribute to a Coverdell ESA (which can be used to save for pre-college education costs). However, because contributions to a Coverdell ESA are limited to $2,000 a year, you are concerned that the funds in the account will not be enough to pay for elementary, secondary, and post-s econdary school, so you contribute to a 529 plan as well.

Just do something!
Don't let all these deliberations prevent you from socking away some money as soon as possible. Saving something is much better than delaying while you solve the college account conundrum. Due to the higher contribution limits and favorable financial-aid treatment, 529 savings plans are the best deals for most people. If your state offers benefits for participating in its 529 plan, and the plan offers at least five investment options that don't charge more than 1.25% annually, then consider signing up with the home team. If you decide later that it isn't the best plan for you, transfer to another 529 plan.

If you're leaning toward a Coverdell ESA but still have doubts, go ahead and open one. The funds can be transferred to a 529 plan without penalty. (However, the other way around -- taking money from a 529 plan and putting it in a Coverdell ESA -- will incur distribution penalties, and this won't get you around the $2,000 annual contribution limit.) You can switch later if additional research and/or financial-aid considerations convince you that a 529 plan will be better. (If you're making the switch for financial-aid reasons, make sure the transfer is completed before Dec. 31 of your child's junior year in high school.)

So don't dally -- start saving NOW!

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