(Here's part one if you missed it.)

If you have kids, chances are that you will suffer “College Sticker Shock” at some time in the future.  The shock comes when you write those checks for tuition, room and board, books, lab fees and the assorted other expenses associated with the cost of sending your offspring to a college or university.  The cost of education at a college or university goes up significantly every year.  If you are thinking about paying for all or only a portion of your child’s college education, you had better be taking action today.

Last month in this column I made the case that today’s parents with young children have a much better chance of meeting the challenge of funding those college expenses than previous generations.  Thanks to the new incentives the lawmakers have provided there are two very good savings vehicles available.  Last month I covered 529 plans.  This month I will summarize the Coverdell Education Savings Account or “ESA”

Recent legislation has replaced what used to be called the “Education IRA” with the new improved Coverdell Education Savings Account.  If you have a good handle on the concept of the Individual Retirement Accounts then you are well on your way to understanding the basic concepts behind the Coverdell ESA.
Like IRA’s ESA’s have contribution limits, age maximums and a broad choice of investment vehicles.  Your contributions are limited to $2,000 per year and you can’t contribute to an ESA once the beneficiary reaches age of 18.  You can set up an ESA for any family member who meets the age requirements and you don’t have to be the parent of that child.  However the total contributions for any one child can not exceed $2,000 per year so that can be a little tricky coordinating with grandparents who may wish to make contributions.  
Also, your income must be below a certain level in the year of your contribution. Contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution. The $2,000 maximum contribution  is gradually phased out if your modified adjusted gross income falls between $190,000 and $220,000 ($95,000 and $110,000 for single filers).

Once in the plan the account grows without the drag of income tax and when funds came out, they do so on a tax-free basis, as long as they were used for qualified educational expenses.  Along with the increase in contribution limits the definition of qualified educational expenses has been expanded to include expenses at the elementary and secondary levels as well as the college level.  For parents considering private grade and high schools this represents a distinct advantage.  

With the Coverdell ESA you do enjoy more flexibility in investment choices over the 529 plans.  529 plans are typically limited to the choices that are offered in the plans that each of the 50 states offer.  For those parents who wish to manage their own plans, this is easier to do with a Coverdell than any of the 529 plans.   Individual stocks, bonds and mutual funds can be used in the Coverdell, while the choices in the 529 plans are limited to the mutual funds they offer or the customized portfolios that are managed by professional investment managers

Compared to the 529 plans offered by the 50 states, those are really the only advantages the Coverdell ESA has.  The list of disadvantages is rather lengthy.

A big disadvantage of the Coverdell surfaces when applying for federal financial aid. The account is considered an asset of the student, not the parent.   This means that 30% of the account balance must be considered in the aid process and that can have a huge impact on the amount of need based assistance the student may receive.  With 529 plans the account is deemed an asset of the parents and only 5% of the balance is considered in the federal aid process.  This treatment of the Coverdell is a throw-back to the old days when custodial accounts were the primary source of saving for college.  Those accounts were and continue to be considered as an asset of the student and not the parents.  

Withdrawals while in college can also produce a harsh effect on the following year's aid eligibility because it is counted as student's income. There is not a great deal of reliable information available yet as to the treatment of distributions from Coverdells and 529 plans when it comes to financial aid calculations.  It is probably safe to assume that the Coverdell will not receive preferential treatment over the 529 plan.
  
The control of the Coverdell account also has some distinct disadvantages when compared to 529 plans.  While you can change the beneficiary of the account to other dependents, those dependents must be individuals that you are responsible for either as a parent or a guardian.  Additionally the funds have to be distributed to them by their 30th birthday.  The funds cannot be returned back to you as they can with a 529 plan. 

A sound college savings plan should be built around a 529 plan.  It offers tremendous advantages and incentives over conventional savings programs and the flexibility of the contributions and withdrawals are tough to beat.  Coverdell ESA’s can be used as well for college funding but they make the most sense when the parents are pretty sure they will be sending their children to private grade and high schools.  When it comes to college savings the 529 plan is the better option.

As with any savings goal, your biggest enemy is not starting soon enough.  The cost of college is increasing at a rate roughly twice that of the historical rate of inflation .  If you have children start saving today.  Don’t wait for a better time, because it will never come.  The only way to avoid “College Sticker Shock” is to start early and contribute often.  You will be very glad you did when this time of the year rolls around and you have to write those checks for college.

Contact Mark Neil at:
Northwest Wealth Advisors, Inc 
0605 SW Taylors Ferry Road
Portland, OR 97219
Office: (503) 478-6632 
Fax: (503) 595-1863 
Email: mneil@nwwealtadvisors.com 

© 2003 Mark Neil