When the Bills Come Due
Tread mighty carefully when tapping your college savings accounts
After you've spent down the assets that are considered detrimental to financial aid eligibility, the next type of account to consider tapping is a Coverdell ESA.
Coverdells have a lot in common with 529 savings plans, an increasingly popular college savings vehicle that is considered by many to be the 401(k) for college savings. For example, Coverdell accounts and 529 plans--which are sponsored by virtually all 50 states--let parents invest money through mutual funds or similar investment options in a tax-deferred setting. In both Coverdells and 529s, money withdrawn for qualified educational expenses, including tuition, mandatory student fees, room and board, and other required expenses, can be taken out tax free, a feature that makes both accounts quite attractive to tax-conscious investors.
In both types of accounts, the assets are considered to be the property of the parent (or whoever opened the account) and not the student beneficiary. This wasn't always the case. Coverdells used to be considered an asset of the student beneficiary, but that was changed in 2004 by a ruling from the Department of Education. So today, both Coverdells and 529 savings plans prove beneficial from a financial aid standpoint.
But there's one big difference. Under the rules of the Coverdell, balances saved up in these plans must be used no later than 30 days after the beneficiary turns 30. "If you don't use it up by 30, the earnings will come out taxable," says Susan Hirshman, a wealth strategist with JPMorgan Funds. Moreover, that money may be subject to an additional 10 percent penalty tax. The IRS will allow you to roll any Coverdell balances into an account of a family member of the beneficiary, such as a sibling. But again, that beneficiary must be under 30.
Because 529 savings plans are the most flexible--there is no age at which the money must be used, the assets can be transferred to a relative of the original beneficiary, and there are often state tax breaks--it makes sense to keep those assets invested and sheltered from taxes the longest. If need be, money that's not used up can be rolled back into the parent's name or into the name of a grandchild to be used for educational expenses.
For those with multiple 529 accounts, it makes sense to consider their overall performance and cost, says John Heywood, a principal in charge of the mutual fund giant Vanguard's education markets group. If one of the plans has solid investment options and low fees while another is only so-so and carries high expenses, then consider liquidating the high-fee plan first. This will allow you to shelter your most beneficial plan the longest. Also, if you are using one 529 to invest mostly in stocks and another to invest mainly in fixed-income investments, an easy option is to tap the higher-risk, equity-laden portfolio first.
Here's one more bit of advice: If you're withdrawing assets from a 529 to pay for qualified educational expenses, make sure you withdraw the money in the same calendar year as the bill to keep the IRS happy, says Joseph Hurley, CEO of the website savingforcollege.com.
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