Saving for College: Is 529 My Only Option?

"I have a seven month old daughter for whom we are starting to save for college.  We have opened a 529, but worry about her being penalized on withdrawals if she doesn’t require the money for educational purposes (e.g. she has scholarships).  Are there any other tax-sheltered ways to save for her future that don’t have the same requirement for qualified educational expenses?" 

Thank you for your question.  529 Plans are terrific investment options to save for a child’s education and it is even better that you have started one at such a young age.  To answer your question, there is another option called a Coverdell Education Savings Account (ESA).  If you are familiar with how Roth IRA’s work then you have the basics about how the Coverdell works.  Here are the important points regarding the Coverdell ESA.

• Contribution limited to $2000 per child per year.  This gets a little tricky since this limit is per child from all sources so you could not contribute $2000 for your daughter AND your parents could not contribute $2000 for their granddaughter.  You could, however, each contribute $1000.  (No annual contribution limits in a 529, very high maximum account balance varies by plan)
• Income limits imposed that limit who can contribute to a Coverdell ESA.  In 2013, these phaseouts begin at a modified adjusted gross income (MAGI) of $95,000 for single taxpayers and $190,000 for married taxpayers.    (No income limits on a 529)
• Accounts can be opened at most banks and financial institutions and the funds can be invested in a large variety of investment options, mutual funds, stocks, bonds, ETF’s, etc.  (Limited to investment choices within state plans)
• Tax free growth within the account and tax free distributions if used for qualified educational expenses.  (Similar to a 529)
• Qualified education expenses include elementary, secondary and post-secondary education.  (529 only includes post-secondary)
• Withdrawals from the account not for educational purposes are subject to income tax on the earnings portion and a 10% penalty on the earnings (Similar to 529)
• Penalty exception for death or disability of beneficiary or a scholarship earned by the beneficiary (similar to a 529)
• Funds within the Coverdell ESA must be used by the time the beneficiary reaches the age of 30 or must be transferred to another family member.  (no age limit on 529)

I know those details aren’t the most exciting reading, but they are critical in explaining a Coverdell ESA and also demonstrating how a 529 compares.   Not that you asked for it, but here is my opinion of appropriate uses for each.

If you want to send your daughter to private elementary or secondary education, then the only tax advantaged option is the Coverdell ESA, assuming you are eligible to contribute.

If you are looking for saving for your daughter’s college education then the 529 is still your best option.  If your daughter is fortunate enough to receive scholarships, then she will still be able to withdraw from the 529 for those expenses without paying the 10% penalty.  She will still have to pay income taxes on the earnings, but she will probably be in a low tax bracket.  All the tax deferred growth should still be worth it.  In my opinion the only shortcoming of the 529 is that your investment options are more limited than they would be with a Coverdell.  Given the numerous plans available, however, you should be able to find a plan with investment options that align with your investment strategy.