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Save More for College with the Coverdell ESA

by retirebyforty on August 8, 2014 · 32 comments

in education, investing

save for retirement first or children's education

One of my missions in life is to pay for our kid’s college education. My parents helped me with my education and that paved the way for our financially stable life. I know college isn’t right for everyone, but let’s save first and if he doesn’t attend college, we can always gift the account to other kids in the family or even earmark it for future generations. It’s better to sacrifice now and save up front than for our kid to be saddled with a big debt load.

College cost skyrocketing

Do you know how much college will cost in 15 years? According to the College Cost Calculator from savingforcollege.com, it will cost $313,615 to attend our alma mater (UCSB) for 4 years as a California resident. Okay, California is a pretty expensive state, so let’s try University of Oregon instead. That way we don’t have to move to California to get the in-state tuition.

Currently it cost about $25,000 per year to attend UO as an Oregon resident. I put that number into the calculator and the result turned out to be $221,771. That’s a lot better, but it’s still ridiculously expensive. Let’s just shoot for a nice round quarter of a million dollars. If it costs more than that, then he’ll have to get some loans and be more creative about financing his education.

529 Plan

We opened a 529 college account the same year RB40 Jr. was born. Oregon has a high state income tax (10%) and the 529 offers a tax deduction up to $4,530 for married filing jointly (2014.) That’s not bad and I’ll take any tax deduction I can get. The other big tax advantage of the 529 is that you won’t have to pay any tax on the earnings if you use the money for higher education.

My plan is to front load the 529 to maximize the tax advantage the 529 offers. Saving more upfront will enable the account to compound and grow over 18 years. Here is an example.

  • If you save $70,000 when your kid is born, you’ll accumulate $294,040 (assuming 8% annual gain.) That’s $224,000 in earnings that you don’t have to pay tax on!
  • If you spread it out over 18 years and save $324/month until your kid is 18, then you’ll have $156,585. It’s still a nice amount, but probably won’t be enough to pay for 4 years of college.

Of course, we don’t have a briefcase with $70,000 lying around. However, we can save about $10,000 per year while our kid is still young. Once we contribute $50,000, then we’ll evaluate the whole picture again. So far we contributed about $28,000 and gained over $9,000. That’s about 15% to a quarter million bucks.

There is one problem with the 529 plan. The 529 has limited investment choices. For now, we invest in US and International index funds, 50/50. It would be nice to invest in low cost index funds and individual stocks.

Coverdell Education Saving Account

I found out about the Coverdell ESA late last year and I’ve been meaning to look into it. From my research, it’s pretty much an educational Roth IRA. The earning is tax free if you use it for educational expenses. Now that it’s more than half way through 2014, it’s time to get the ball rolling with this. Let’s look at the pros and cons of a Coverdell ESA.

Pros

  • Investment choice – You can invest in anything you want in the Coverdell ESA.
  • Tax – Earning grow tax deferred. The fund won’t be taxed if used for qualified educational expenses.
  • K-12 expenses – You can use the Coverdell ESA to cover qualified elementary and secondary education expenses.
  • Transferable – The account can be transferred to another family member if needed.
  • Favorable Financial Aid calculation – If a parent owns the ESA, then up to 5.6% of the value is included in the financial aid eligibility calculation. If the student owns the ESA, then it won’t be counted in the calculation.

Cons

  • The contribution is not tax deductible. :(
  • $2,000/year limit per child. That’s not much.
  • There is an income limit. For joint filers, if your MAGI is more than $190,000/year, then the benefit will phase out. One work around is to give the money to the child and he/she can open their own Coverdell ESA.
  • There is a time limit. You can only contribute until the beneficiary is 18. The fund must be used by the time he/she is 30. If the fund is not used, then the earning will be taxed as ordinary income plus 10% penalty.

Well, it looks like the Coverdell ESA is pretty similar to the 529. The main difference is the investment choices and the ability to use it for K-12 education expense. It’s a good option for us because we plan to contribute more than the state tax deductible amount, $4,530. We can put $2,000 in the Coverdell ESA and $8,000 in the 529. I like the flexibility of the ESA because I can invest in low cost index funds and individual stocks.

Where to open

I called Vanguard and found out that they removed ESAs from their product offering. If you have an ESA account with them already, they will continue to support it, but no new accounts. That’s too bad because most of my retirement accounts are at Vanguard now and it would have been convenient.

I called my other broker, Firstrade, and they offer the Coverdell ESA there. I just got the paperwork and will fill it out soon. They also don’t have any maintenance fees for active accounts so that’s great.

Overall, I think the Coverdell ESA is a good complement to the 529 if you plan to contribute more than you can deduct from the state income tax. It’s flexible and the earning will grow tax free. If you contribute less, then it’s probably easier to just go with 529.

Are you saving for higher education? Do you think it is worth it to sacrifice up front so the kids don’t have to carry a lot of debt when they start out?

{ 32 comments… read them below or add one }

Shane August 8, 2014 at 5:58 am

I work at a college and there is an interesting debate as to whether or not parents should save for their kids college education. There are many people that feel that if kids want to go to college they find ways to pay for most of it themselves instead of parents paying for it. The reasoning being that kids will build a work ethic and sense of pride knowing that they accomplished a major life purchase pretty much on their own and not given to them by their parents. I would be interested to see how others feel concerning this issue. Good post.

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Dividend Growth Investor August 8, 2014 at 8:34 am

The ESA option sounds pretty nice, because you can invest in whatever you want. The thing that I don’t like is the mandatory distribution by age 30. Of course if your kid has kids by the time he is 30, he can transfer the money to his kid, which would increase tax-deferral forever.

I would be interested in a 529, where you can essentially grow money tax-free for decades, and never have to make a distribution. Hence, it could be similar to a 401K, however without tax-advantages, ( other than tax free compounding, and at state level) Sure, when you withdraw for non-college expenses you get hit by a penalty, but if you manage your tax-brackets well, you can essentially end up paying very little in total taxes.

The only issue is with 529 the limited investment options..

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retirebyforty August 8, 2014 at 9:43 am

I would hate to pay the 10% penalty on the 529. At that point, it’s probably better to transfer to another kid in the family.

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Cindy August 8, 2014 at 11:12 am

In my state, you get a 20% state tax credit (up to $2,000) for money invested in a 529 plan. However, if you use the money for something other than qualified educational expenses, not only are you hit with the 10% penalty, but you have to pay back the tax credit.

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retirebyforty August 8, 2014 at 9:39 am

That’s probably true, but it seems most kids will need to borrow money and end up owing a lot. Maybe we’ll pay half his college cost, then surprise him by paying off the student loan when he graduated.

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Jay August 10, 2014 at 12:29 pm

That’s an interesting perspective. However, I feel the complete opposite. My parents worked obscene hours in fast food in an effort to provide as much as possible to my siblings and I and THAT is what taught us work ethic. I was lucky to have such hard working parents (quick story about that in my very first post if you’re interested) and I think that instills more work ethic than simply being thrown to the wolves.

Jay

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retirebyforty August 11, 2014 at 9:42 am

My parents worked a lot too. They sacrificed a lot for the kids and it made us study harder in school.

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Zol August 12, 2014 at 11:04 am

I like the half and half approach (gift surprise at the end). Kids gotta have some skin in the game. I had about 50/50 but i am an engineer and coops came out with very little debt. My brother was 75/25 (lets say he partied alot). And my youngest brother was 100% covered (lets just say he’s going on year #6).

P.S. This grey cube is soul sucking, you know what i mean =P

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nicoleandmaggie August 8, 2014 at 6:32 am

I don’t see the point in a coverdell account. Why not just open a second 529 in Utah or another state that has Vanguard funds? Our state doesn’t have any 529 tax breaks, so we save everything in a Utah 529.

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retirebyforty August 8, 2014 at 9:40 am

That’s a good point. I guess the big advantage is if you want to invest in individual stocks.

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John August 8, 2014 at 7:14 am

We’re planning on helping our kids and are saving now, but it takes a back seat to our saving for retirement. I think there’s so much that goes on beyond the actual cost, and that is something we’re going to be focusing on a lot so they can make the best decision for themselves.

The brokerage I worked at offered Coverdell accounts. They do have a lot of cons to them, but I like the flexibility of them as well as the ability to invest in whatever you want. I’d go the 529 route first, but this can be a good secondary option.

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retirebyforty August 8, 2014 at 9:41 am

I place higher education before retirement saving. Luckily, we can do both right now.

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Ginger August 10, 2014 at 11:27 am

I place retirement savings above college savings because I can always cut down on retirement savings and cash flow college or pull from my Roth IRA and that way there is no chance of penalties. That being said, once I max out on the Roths and 401ks, I do plan to open a education IRA (as they used to called ;) ) and possibly a 529 depending on tax benefits in the state I am in.

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lius August 8, 2014 at 8:45 am

The pro of ESA usage for K-12 is offset by the time often needed for investments in ESA accounts to grow and compound.

Another option is EE bond which guarantees a doubling in 20 years as a hedge against any major equity downfall.

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retirebyforty August 8, 2014 at 9:44 am

You’re right. $2,000 per year isn’t much. A year of private school cost over $10,000 so it’s probably not useful for major expenses. I would save it for college anyway.

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Tommy August 8, 2014 at 9:14 am

I have no 529 advise to offer but just my experience faced with raising 3 kids. They are all vastly different and when they reach the age to make a college decision they can surprise you. When the time came my son turned out to be a more hands-on artistic type. He chose to go to a trade-school and became an automotive painter and I handled his education expenses without any savings. I did save in a regular savings account (interest paid was higher in the late 90s early 2000s) for my daughters and told them I would pay for their 2 years at the Community College and if they did well and wanted to continue I would help them with further education. One decided 6 months in that she wanted to experience life, not sit in class and the other did her 2 years and went beyond community college. I did pay for their education that they did and they are successful today. I agree that helping your kids get a start is important. There are too many today with obscene student loan obligations. I guess my point is its good to save somewhere so that if they do choose a more expensive route you are prepared to help. However, I do see merit to setting limitations on what you will pay so you don’t derail any of your other financial plans and if they decide to go beyond then as Shane commented to this post earlier it may be healthy that they have some skin in the game with a “reasonable” student loan. Your $10K a year looks like a plan if you can swing it. However, who knows what a college education will cost 15 to 18 years from now. It could go either way depending on educational choices made and any kind of educational reform.

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retirebyforty August 8, 2014 at 9:47 am

Thank you for sharing your experience. $10k per year is tough now, but I think it will pay off later. If our kid doesn’t go to college, then we can help pay for the other kids in our family. Of course, you’re right about having skin in the game. Maybe we can pay for half his college cost and then help pay off the student loans later. We’ll see how it turns out in 15 years. :)

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Tawcan August 8, 2014 at 10:30 am

We have started RESP for our little one when he was born and we plan to do the same for other kids as well (we plan to have more kids). My parents paid for my university education as well and I really appreciate that. My goal is to do the same for my kid(s). Having said that I do think having a part job while in university/college is a good experience.

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retirebyforty August 8, 2014 at 4:47 pm

Great job! I really appreciated my parent’s help too. I don’t know where I’d be without the help.

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Kenny August 8, 2014 at 11:04 am

Best of the best plan is ‘Prepaid Tuition’. Everything else has a risk associated with it. Coverdell and 529 is money in your hands to invest. You are competing with 11% inflation (avg) on college tuition and boarding. And, if your returns do NOT keep up with that amount, which is hard even with 100% in stocks, then what? Also, what if your kid has to go to college and that year turns out to be 2008? I know a bunch of parents where that happened to them, and even though they had the money set aside, they dipped into their savings to avoid taking money that took a 38% dip in 2008. Now you are screwed since the funding in 529 that you planned did not help, and also you had to take money from what was ear marked for retirement (remember at that point when you kid goes to college, you are ‘old’!!!!).

I did the Prepaid, planned everything around it accordingly, and it is a BEAUTIFUL thing since I have designated that in my kids college profile, and I never see a bill except for some odd things that the kid purchases from the college bookstore that invariably gets billed through the Univ. Of course, books are outside of it, and my regular 529 (another account) funds it. And, if you know my background from other postings, I bought a condo to side step the $12000 per child per year of Condo costs.

Kenny

Kenny

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Cindy August 8, 2014 at 11:24 am

But what happens if your child wants to go to a different school? Doesn’t the prepaid tuition only apply to certain school(s)? If they decide not to go at all, can you get your money back? What if they drop out?

I don’t think there’s any such thing as fool proof when planning for the future, especially for when you’re planning for what your children will decide to do at 18. My Dad did everything in his power to try to force my older sister to go to college, from making her apply, to filling out her paperwork and picking her classes. When push came to shove, she wouldn’t get in the car. Even kicking her out of the house didn’t persuade her. You can never be 100% sure!

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brian August 15, 2014 at 4:49 pm

This is my exact issue/concern with the pre-paid plans. On paper they sound fantastic, but I can tell you I didn’t know where I wanted to go to school until the beginning of my Senior year of HS. I lived in 4 states before the age of 8; imagine being my parents if they had chosen this route, where would I have been?

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retirebyforty August 8, 2014 at 4:50 pm

I don’t really like prepaid tuition because I don’t even know where the kid would go to school. I know the 11% inflation is high, but we should be able to overcome that with extra saving. It’s not the best way to go, but it’s more flexible. I plan to move most investment to bond when college is around 4-5 years away. That should help, but of course, we’ll see less gain.
If you know where the kids would go, then prepaid is a great idea.

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Chris August 8, 2014 at 11:06 am

My wife and I are also trying to invest a lot early on in 529s for our children with a plan to slow down once each account reaches somewhere in the 75-100k range and then see what develops in terms of college costs, investment returns and our children’s interests and aptitudes. My wife is a bit of a Tiger Mom and she has made it clear that we must pay for the full cost of the best school our children can get into, so it’s best to get started early and be prepared.

In my state the deductions extend up to 16k annually for married filing jointly, which is helpful. We are happy with the Vanguard funds available as they have expense ratios of about 0.3%. One other option I’m considering is diverting a smaller portion of our college savings toward I-bonds. While they can be tax advantaged when used for education within certain income ranges, we are more interested in having funds that could be used to pay expenses that the 529 can’t, such as travel or a vehicle. My understanding is that children can own them if they are linked to an adult’s account.

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Cindy August 8, 2014 at 11:35 am

The boyfriend and I don’t plan to have children, and his youngest is already a Junior in college, so we’ll likely never need to worry about any of this. When I went back to school for my Masters a few years ago, I did use a loophole in the 529 Plan to my advantage. My state offers a 20% tax credit on money invested into a 529 Plan, up to a $2,000 credit per year. You have to pay back the credit (plus the 10% penalty) if the money isn’t used for qualifying education, but there’s nothing that says how long the money has to stay in the account. And you don’t have to put the money into an investment (at least in my state), you can leave it in a “cash” account. Since I was paying around $3,000 cash per year for classes, I would put the money into my 529 Plan the year before, get the $600 tax credit, and then use the $3,000 the following calendar year to pay for school. It made for a nice return on my “investment”, with zero risk.

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retirebyforty August 8, 2014 at 4:52 pm

Nice job with the loop hole. :) Good idea with no more kids. They are too expensive these days.

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Wilson August 8, 2014 at 1:49 pm

We’ve been doing a Coverdell to supplement our 529 for our daughter primarily b/c of the flexibility it offers as to how soon it can be used. Our local public schools are trying valiantly but overextended and do not offer enough quality slots for all able students. Hence private school will be a likely possibility when she comes of sufficient age, and a Coverdell could provide some emergency flexibility depending on how fruitful my endeavors are and how easy I’m taking it in 10 plus years. I’m doing a Nevada 529 as this age still provides unbridled hope that she’ll test out of our so-so State U so no tax benefit concerns for me. Been meaning to change my place-holder investments in the 529 to Vanguard funds; thanks for the reminder to do that.

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retirebyforty August 8, 2014 at 4:55 pm

Private school would hit the Coverdell fund very hard. Unless we’re really well off by then, I don’t think we’ll send our kid to private school. We went through the public school system and it’s not bad. We’ll see. We would consider homeschooling before private school…

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Ginger August 10, 2014 at 11:41 am

I’m a private school kid and do plan to use the coverdell as a high school saving account (after maxing our retirement) because private schools don’t have to follow many of the rules public schools have to and even when I was a kid I saw I difference in the depth we private school kids were taught, on average.

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Marie August 9, 2014 at 6:01 am

Me and my hubs are saving for our daughter’s college. We don’t want her to have a student loan in the future, we would love to give her a good education.

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Thias August 10, 2014 at 6:40 am

The wife and I don’t have any kids yet but that hasn’t stopped me from starting to figure our future strategies. We are planning on using a 529 plan and will pay for a portion of our children’s student loans. I paid for college entirely by myself and I can’t say enough about the motivation of having skin in the game. We will also have some sort of contingencies for grades required for our continued help with tuition.

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brian August 15, 2014 at 5:05 pm

I was lucky that my parents were able to pay for my degree; I had to pay for school when I went back right after graduating, but that was fine, that was my decision. We are doing what we can to provide the same thing for our son, but we have a quirk in that college starts right about when we’re looking at early retirement, so things could get real interesting. I would love to provide the same benefit to my son that my parents did my me.

Several people mentioned the “what if my child doesn’t go to college? now what?” From what I’ve read, the 529 can be transferred to a relative, including the parents, and since my wife and I was nerds, I’m pretty sure we’d have no trouble sitting in on some classes, and then if we don’t use all of it, if the timing is right, we could just transfer it to a grandchild. Trade schools also qualify, so that’s a plus if our son decides to go that route as well.

Also, if your state plan doesn’t offer tax benefits for contributing to a 529 (ours doesn’t!), the NY State 529 looks to be the best one that I’ve seen: Vanguard funds and a consistent 0.17% fee (even lower than going with Vanguard direct for a 529)

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