There is more than one way to save for college

With changes coming to Coverdell Education Savings Accounts in 2011, some parents are wondering if they should convert their Coverdells to 529 plans.

Coverdell ESAs were popular because they worked like a Roth IRA for college savings. Contributions to a Coverdell ESA aren’t deductible, but you get tax-deferred growth. Withdrawals from Coverdells are (currently) tax-free if used for qualified educational expenses such as tuition, fees and books, as well as certain K-12 education costs. Coverdell account assets can be allocated among many investment vehicles, and many banks, credit unions and mutual fund providers offer these accounts.

The (current) annual contribution limit to a Coverdell is $2,000, and phase-outs kick in at $95,000 for single filers and $190,000 for married filers. Beneficiaries must be younger than 18 when the account is set up, and the money in the account must be spent or transferred before they turn 30.

However, beginning in 2011:

  • The annual contribution limit drops from $2,000 to $500.
  • A portion of the withdrawals will be taxed as ordinary income.
  • A 10 percent penalty applies if a withdrawal is not used for education expenses.
  • No withdrawals may be used to pay K-12 education expenses.

Many parents are thinking about shifting their Coverdell funds to a 529 plan.

You can do a rollover from a Coverdell ESA to a 529 plan without incurring any tax penalties as long as the 529 plan will have the same beneficiary as the present Coverdell account. Under federal tax law, withdrawals from a 529 plan are tax-free – assuming they are used for qualified education expenses – but contributions are taxed.

You can put much more money into a 529 annually. You can put up to $13,000 in a 529 plan this year without having to file a gift tax report. Your spouse can, too. So can relatives. Any individual taxpayer can contribute up to $13,000 to a 529 plan in 2010.

And the owner of a 529 plan retains control of the assets and has the power to change the beneficiary. You can even start multiple 529 plans.

In many respects, 529 plans have left Coverdell ESAs in the dust.

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