529 Plans vs. Coverdell Education Savings Accounts

The Section 529 plan and Coverdell Education Savings Account (ESA) are two of the most popular ways to save for college. But which savings option is right for you?

Definitions
A Coverdell ESA is a tax-advantaged savings vehicle that lets you save money for the qualified education expenses of a named beneficiary, such as a child or grandchild. Qualified education expenses include college expenses and certain elementary and secondary school expenses.

529 plans are tax-advantaged savings vehicles that let you save money for the college expenses of a named beneficiary, such as a child or grandchild. There are two types of 529 plans–college savings plans and prepaid tuition plans. A college savings plan lets you save money in an individual investment account. A prepaid tuition plan pools your contributions with those of other investors and allows you to prepay the cost of college at today’s prices for use in the future.

Contribution limits and restrictions
The annual contribution limit for Coverdell ESAs is $2,000 per beneficiary. That’s considerably less than you can contribute to most 529 plans (most plans have lifetime contribution limits of at least $250,000 total). So the more money you have to invest, the more attractive a 529 plan becomes. Just make sure you’re familiar with all the contribution rules before you invest in a 529 plan. In addition to the lifetime contribution limit, some plans impose annual maximums and/or minimums. Another potential drawback of the Coverdell ESA is that you may not be able to contribute if you earn over a certain amount for the year.

The age of the beneficiary also limits the use of a Coverdell ESA. You can’t start a Coverdell ESA after the beneficiary reaches age 18. The exception is if the beneficiary is a child who has special needs. This typically means that you can’t keep adding to the kitty once your child’s in college, since most children are at least 18 when they start college. Additionally, a Coverdell ESA that you have properly established cannot continue after the beneficiary reaches age 30 (unless the beneficiary has special needs). By contrast, the federal government imposes no age restrictions on 529 plans. However, a minority of states impose such restrictions of their own (usually only on 529 prepaid tuition plans), so make sure to check with your plan administrator.

Income tax treatment
The tax treatment of Coverdell ESAs and 529 plans is generally similar. At the federal level, there is no deduction for contributions made to a Coverdell ESA or a 529 plan (though states may offer one). And withdrawals from both a Coverdell ESA and a 529 plan that are used to pay the beneficiary’s qualified education expenses (called qualified withdrawals) are free from income tax at the federal level. At the state level, whether the withdrawal is income tax free or deductible from income depends on the state you live in.

Withdrawals from a 529 plan or a Coverdell ESA that are used for purposes other than the beneficiary’s qualified education expenses (called nonqualified withdrawals) aren’t treated as favorably. First, you’ll pay income tax on the earnings portion of the withdrawal. For 529 plans, the person who receives the distribution (typically the account owner) pays the tax, while for Coverdell ESAs, the beneficiary generally pays the tax. Second, you’ll pay a 10 percent federal penalty on the earnings portion. Plus, depending on the state you live in, you may also owe an additional state penalty on the earnings portion.

Control of the account
As the account owner of a 529 account, you decide when withdrawals will be made and for what purpose. You’re also free to change the designated beneficiary, and as long as the new beneficiary fits the definition of a qualified family member of the previous beneficiary, you won’t be penalized for making the change. As a parent or guardian, you generally have these same rights with a Coverdell ESA, but the exact degree of control may depend on the trustee’s policies.

In terms of investment control, though, Coverdell ESAs have the edge. You can set up a Coverdell ESA with any number of banks, mutual fund companies, and other institutions. And you can customize your portfolio, choosing investments on your own. You’re also typically free to move money among a company’s investments or to transfer your Coverdell ESA from one trustee to another as often as you like. Finally, you can take a withdrawal from your Coverdell ESA and roll it over to a Coverdell ESA with a different trustee. The new account can be for the same beneficiary or for a new one within the same family. You can only do one rollover per year, though, and you must complete the rollover within 60 days to avoid tax and penalty.

By contrast, you lack such investment freedom with a 529 plan, though the trend is for college savings plans to offer more investment choices and flexibility. If you’re lucky, at the time you join a college savings plan you’ll get to choose one or more investment portfolios offered by the plan, which typically consist of mutual funds tailored to different investment styles. Otherwise, your contributions will automatically go into a single investment portfolio based solely on your child’s age. In either case, though, you don’t get to choose the underlying mutual funds held in an investment portfolio–the plan’s professional money managers make those decisions. And you can’t move money from fund to fund within the portfolio that you have.

Once you’ve invested money in a portfolio, you have limited opportunities to change investment options if you’re unhappy with the portfolio’s investment performance. Depending on a plan’s individual rules, some plans may let you direct future contributions to a different portfolio. As for your existing contributions, some plans may let you change the investment option once each calendar year without changing the beneficiary, or they may let you change the investment option anytime you do change the beneficiary.

But there’s one option that’s mandated by federal law and not subject to a plan’s discretion. You can change the investment option on your existing contributions without penalty by doing a rollover to another 529 plan (college savings plan or prepaid tuition plan) without changing the beneficiary. However, you’re limited to one such rollover every 12 months. If you want to do more than one rollover in a 12-month period, you’ll need to change the beneficiary to avoid a penalty and taxes.

Financial aid considerations
The federal financial aid treatment of Coverdell ESAs and 529 college savings plans is identical. Each is considered an asset of the parent if the parent is the account owner (which is a more favorable result than if the account were classified as a student asset). Also, distributions (withdrawals) from either a Coverdell ESA or a college savings plan that are used to pay the beneficiary’s qualified education expenses aren’t classified as either parent or student income, which means that some or all of the money is not counted again when it’s withdrawn.

Note: The financial aid treatment of 529 plans and Coverdell ESAs is complex and subject to change. You should consult a financial planner experienced in financial aid issues for more information.

Can you have both?
Yes. You can open both a Coverdell ESA and a 529 account for the same beneficiary. And you can contribute to both types of plans in the same year for the same beneficiary. However, if withdrawals are made from a Coverdell ESA and a 529 account in the same y
ear for the same beneficiary, you’ll need to allocate the qualified education expenses you’re covering between the two accounts. For more information, consult an experienced tax professional.

Contribution limits and restrictions
The annual contribution limit for Coverdell ESAs is $2,000 per beneficiary. That’s considerably less than you can contribute to most 529 plans (most plans have lifetime contribution limits of at least $250,000 total). So the more money you have to invest, the more attractive a 529 plan becomes. Just make sure you’re familiar with all the contribution rules before you invest in a 529 plan. In addition to the lifetime contribution limit, some plans impose annual maximums and/or minimums.

Another potential drawback of the Coverdell ESA is that you may not be able to contribute if you earn over a certain amount for the year. Again, you should seek counsel from a qualified financial planner for more information.

Starting a Home-Based Business

We know. You’re sick and tired of the 9 to 5 grind. You want to escape the commute…escape the water cooler…escape the status meetings. There’s got to be a better way right? There’s got to be a way for you to build your own business.

The advantages of working at home include:

• No commute
• You save money
• Tax benefits
• Family benefits
• Launching pad for your business

Imagine rolling out of bed on a cold winter day, and with your hair still disheveled, sliding on your slippers. You get a cup of steaming hot chocolate loaded with marshmallows and stroll into your office, which is located next to your bedroom. Sounds enticing–doesn’t it? Well, for many people this is work. And this is one of its advantages.

By working at home you save on commuting expenses and more. Since you already pay the mortgage or rent, you’ll have no additional charges for office space. You may even be able to deduct the home expenses associated with the section of your house used as an office. Additionally, you get to spend more time at home with family. And last, but not least, working at home can be a good way to measure the viability of your new business.

What are the disadvantages of working at home?

Working at home does have its disadvantages, however. They include:

• Home distractions
• Work distractions
• Motivational problems
• Lack of interaction with others

If you work at home, you can be easily distracted. If people know you’re home they will call you. And don’t think that your two-year-old will be able to read the “do not disturb” sign on your door, let alone know what those words mean. If that’s not enough, think of how seductive your leather sofa will look in the morning, especially when your favorite talk show or soap is airing. Recall those days when you couldn’t motivate yourself to jump in the car and drive to work. Imagine how much harder it will be if your office is next to your bedroom. It might, however, be just the opposite for you. Maybe you’re the type who keeps thinking about work. In that case, you might constantly venture into the office when you’re bored, or when you want to develop an idea that’s popped into your head. Another problem exists for those gregarious folk. If you like mixing with others, you might find work at home awfully lonely. There will also be times when the walls of your home remind you of work. Whether working at home is right for you ultimately depends upon your preferences and personality.

Favorable tax treatment
If you work from your home, you may receive favorable tax treatment–if, of course, you follow the rules. The portion of your home used for business must be used “regularly and exclusively” for business purposes. Your home office must also be the principal place that you conduct your trade or business, or a place where you regularly meet with clients, customers, or patients. If you meet all of the requirements, you can deduct that portion of your home expenses that would be deductible if incurred in a trade or business and that is allocated to the section of your home dedicated to your business.

For example, if your home covers 4,000 square feet, and your home office occupies 1,000 square feet, you may be able to deduct 25 percent of your home expenses (1,000 / 4,000 = 0.25 or 25 percent).

Caution: The tax implications of a home office are complicated. Further, a home office may affect the tax treatment of the sale of your home.

Other considerations
In addition to the aforementioned advantages, disadvantages, and tax implications, there are some things you should know and do.

Check local zoning regulations
Some cities have zoning regulations that prohibit or limit home businesses. Check to see if your locality does.

Don’t quit your job yet
If you’re working now, don’t quit too soon. Wait to see if your home business can support you.

Be professional
Have a fax machine, a separate phone line, and quality bond paper. Remember, if you’re not a big business, you can still look like one.

Keep thorough records
You can probably take a deduction for the portion of your home expense dedicated to your business. However, you must be sure to keep thorough records of all your expenses and transactions. Make sure you don’t commingle funds. Use company checks to pay for business expenses, for example.

Think about benefits
If you’re not covered under someone else’s plan, you’ll need health insurance. You can call your local chamber of commerce for information on affordable coverage. In addition to health insurance, you’ll need to consider retirement plans: simplified employee pension plans (SEPs),individual retirement accounts (IRAs), or Keogh plans.

Write your business plan
Next, you should begin preparation for your business plan. The business plan is the blueprint of your business. This blueprint will guide the future of the business as well as serve as a means to measure its success.

Grow your business
To do this, you’ll need to actively seek out potential customers and introduce them to your business. Get to know who buys your product or uses your service. What do they have in common? How can you find others with similar needs? Test out your marketing ideas on friends and family, and don’t be afraid to leave the house and hit the pavement. Yes, you are the salesperson as well as the owner, manager, and marketer. Finally, focus on your strengths. Do what you do best and hire others to do the rest.

Saving for College

College costs
For the 2006/2007 college year, the annual cost of attendance (known as the COA figure) for four-year public colleges is $16,357 and for four-year private colleges, $33,301. The COA figure includes tuition and fees, room and board, books and supplies, transportation, and personal expenses. (Source: The College Board’s 2006 Trends in College Pricing Report.)

The trend of annual college costs outpacing inflation is expected to continue. There are many reasons why colleges find it difficult to hold down price increases from year to year. The main factors are continually increasing salary, maintenance, energy, technology, and recruiting costs, along with the goal of providing students with more sophisticated dormitories, dining halls, recreation and health care facilities, career centers, and campus security.

College savings options
It is important for parents to start putting money aside for college as early as possible. But where…and how? There are many possibilities, each with varied features. For example, some options offer tax advantages, some are more costly to establish, some charge management fees, some require parental income to be below a certain level, and some impose penalties if the money is not used for college.

Here is a brief list of options (which a qualified financial adviser can assist you in selecting).

• 529 college savings plans
• Coverdell education savings accounts
• Custodial accounts (UGMA/UTMA)
• Series EE bonds
• Traditional IRAs and Roth IRAs
• Employer-sponsored retirement plans
• Employee stock purchase plans
• Options unique to business owners

There are several factors to considering options:

Tax advantages
Money saved for college goes a lot further when it’s allowed to accumulate tax free or tax deferred. To come out ahead in the college savings game, it’s wise to consider tax-advantaged strategies.

Kiddie tax
Many parents believe they can shift assets to their child in order to avoid high income taxes. This strategy works best if the child is age 18 or older. If the child is under age 18, the kiddie tax rules apply.

Financial aid
Whether or not a child will qualify for financial aid (e.g., loan, grant, scholarship, or work-study) may affect parental savings decisions. The majority of financial aid is need-based, meaning that it’s based on a family’s ability to pay.

Predicting whether a child will qualify for financial aid many years down the road is an inexact science. Some families with incomes of $100,000 or more may qualify for aid, while those with lesser incomes may not. Income is only one of the factors used to determine financial aid eligibility. Other factors include amount of assets, family size, number of household members in college at the same time, and the existence of any special personal or financial circumstances.

If a child is expected to qualify for financial aid (and most do), parents should be aware of the formula the federal government uses to calculate aid–called the federal methodology–because there can be a financial aid impact on long-term savings decisions. The more money a family is expected to contribute to college costs, the less financial aid a child will be eligible for.

Time frame
Is the child in preschool or a freshman in high school? Obviously, most college savings strategies work best when the child is many years away from college. With a longer time horizon, parents can be more aggressive in their investments and have more years to take advantage of compounding.

When the child is a toddler up until about middle school (sixth grade or so), we typically recommend putting more money into equity investments because historically, over the long term, equities have provided higher returns than other types of investments (though past performance is no guarantee of future results). Then, as the child moves from middle school to high school, it’s usually wise for parents to start shifting a portion of their equities toward shorter-term, fixed income investments.

If the time frame is only a few years, parents will be limited in their choice of appropriate strategies. For example, if the child were in high school, equities normally would not be a preferred strategy due to the short-term volatility of these investments. Similarly, parents would not have enough time to build up cash value in a life insurance policy.

Amount of money available to invest
The amount of money parents have to invest at a particular time might affect their savings strategies. For example, if parents have only a small amount of money to invest, trusts probably aren’t the best option because they are typically more costly to establish and maintain than other college saving options. In this case, a Coverdell ESA may be more appropriate.
Control issues

Generally, when parents give money or property to their child, they lose control of those assets. Such a loss of parental ownership can take place immediately, as in the case of an outright gift of stock certificates, or it may be delayed, as in the case of a custodial account or trust. In any event, parents must assess their personal feelings about relinquishing control of assets to their child. Some children may not be mature enough to handle such assets, whereas others can be counted on to use them for college costs.

Discussing a college funding plan with your child
As college expenses continue to rise relative to the means of the average family to pay such costs in full, parents may find it helpful to sit down with their older children and discuss ways to pay for college. For example, parents may want to discuss:

• Whether they intend to fund 100 percent of college costs or whether they expect their child to contribute and, if so, in what amount. For example, parents might convey their expectation that their child contribute a certain percentage of all earnings from a part-time job or a portion of all gifts.
• Whether the child will play a role in the savings strategy. For example, parents who want to gift appreciated stock to their child should convey their expectation that the child will apply all of the gains to college costs.
• Whether any money will need to be borrowed, and if so, how much and in whose name the loan(s) will be obtained. The amount that needs to be borrowed may affect the type of college the child applies to (e.g., public or private, top tier or middle tier).
• Whether there will need to be shared financial responsibility during the college years. For example, the child may need to participate in a work-study program or obtain outside work during the college years.

Communicating these expectations ahead of time can prevent unpleasant surprises and help parents and their children better plan for the expenses that lie ahead. Also, an open discussion can give children an increased awareness of the financial burden their parents may be undertaking on their behalf.

Dilemma of saving for college and retirement
For many parents, especially those who started families in their 30s and 40s, the problem of saving for college and retirement at the same time is a nagging reality. At Lightship Mutual, we generally place retirement planning ahead of college planning for the simple fact that
parents have no alternative-financing options for their retirement. On the other hand, their children can potentially earn scholarships, grants, and even take out student loans to self-finance their education.

If saving for both goals is a priority to the client, then we emphasize determining specific time frames and liquidity needs for each goal. This process can be daunting for individuals and typically becomes more manageable with the assistance of a financial planner.

Hello World!

As Lightship Mutual joins the ranks of the online blogosphere, we look forward to providing insightful wit and biting commentary into today’s social, political, and technological events as they relate to your personal finances.

Mission: Blog
The Daily Compass represents the ongoing thoughts, musings, and opinions of the advisors of Lightship Mutual. This forum serves to compliment our monthly newsletter, ‘The Lightship Compass’. If you are not yet on our email list, click here to begin receiving our monthly publication, as well.

Staying true to our overall company’s mission, we believe that this forum belongs to you. We fully anticipate a heavy involvement from our site visitors, and we look forward to providing accurate, clear, fast responses to your questions and comments.

Here Comes the Neighborhood
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