Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

529 Plan Vs. Coverdell Education Savings Account: A Comparison

|Includes: Fidelity® Total Market Index Fund Inv (FSTMX), VTSMX

Summary

The earlier you start investing for college, the better.

Money can compound freely in tax-advantaged investment accounts.

Certain account types make it easier to qualify for financial aid.

There are two great reasons to open a tax-advantaged investment account for your child's education as soon as possible:

1. Your money can grow tax-free as long as your withdrawals are used for qualified education expenses; and

2. The money in these accounts, although earmarked for your child, can count as your asset (the federal financial aid formula treats parental assets more favorably than assets held in a child's name).

The earlier you start investing, the better chance you have to be successful at it. This is especially true when you're investing in the stock market. 

A FEW WORDS ABOUT THE STOCK MARKET

I know a lot of parents who are afraid of the stock market. They think they're doing their child a favor by keeping money in the bank rather than "gambling" with it. Investing in the stock market is not gambling if you act responsibly. It's a way to become part-owner of the companies that we rely on. People who don't own a growing business -- or invest in growing businesses -- are more likely to grow poorer over time. 

You don't need to be a genius to invest in the stock market. A high-school education is more than enough. The key to being a successful investor is to avoid making three major mistakes:

1. Paying for something that is worthless - Investors get burned when their investments completely lose their value (like a stock pick that goes bust). This is totally avoidable. Investing in a total stock market index fund like Fidelity's (FSTMX) or Vanguard's (VTSMX) lets you own thousands of America's largest companies in a one-shot deal. These companies form the backbone of America: They are valuable. This may be the safest and easiest way to invest in the stock market. Taken together, the companies within these funds will always be worth something

2. Overpaying for something that is valuable - People who bought a total stock market index fund at the market peak in October 2007 watched the value of their investment fall by 56%. The people who sold at the bottom turned an imaginary loss into a real (and devastating) one. The brave people who sat tight through the crisis watched their investment rebound and grow by more than 100% over the decade. Not bad for a "mistake." It sucks to overpay for an investment, but as long as you invest through the ups and downs of the stock market, you'll pay a fair price in the end. This concept is called "dollar cost averaging." 

3. Panicking and treating something valuable as if it were worthless. Would you sell your home to a stranger for pennies on the dollar because he told you that you paid too much to live there? Of course not. Don't sell your investments so recklessly either. As we saw in the example above, things can work out OK even if you buy into the market at a bad time.

Let's get back to 529 Plans and Coverdell Education Savings Accounts. These are two popular ways to save for college in a tax-advantaged way. Both plans have their pros and cons, which I've summarized in the table below:

  529 Savings Plan

Coverdell Education Savings Account

Income Limit

None

$110,000 for individual; $220,000 for joint return

Contribution Limit

Up to $14,000 per year before potential gift tax

$2,000 per year (until beneficiary turns 18)

Eligibility

Postsecondary education (i.e. college)

Elementary; secondary; postsecondary education

Investment Options

Offered by state (oftentimes, mutual funds)

Flexible (e.g. stocks; bonds; funds; CDs)

Impact on Financial Aid

Varies by owner, beneficiary and dependency

Varies by owner, beneficiary and dependency

Transferability

No tax consequences for qualified family transfers

No tax consequences for qualified family transfers

Age Limit

Varies by plan (usually no restriction)

Under 18 to open; must use by age 30

Federal Non-Qualified Withdrawal Penalty

Ordinary income tax + 10% (on earnings only)

Ordinary income tax + 10% (on earnings only)

Tax Deductibility

Varies by state; no Federal deductibility

None

I don't own a Coverdell ESA, so I can't speak from personal experience. A Coverdell account may be a good choice for new parents who plan to send a child to private school before college. Unfortunately, the stock market is not a good place to invest money that you may need soon, but you can use a Coverdell account to invest in predictable investments, like a certificate of deposit (CD). I prefer 529 plans because the annual contribution limits are higher and I get a tax break for investing in my state's plan. Almost every state offers a 529 plan and they range from great to terrible. I have experience on both ends of the spectrum. Here's what you need to know:

1. You don't need a financial adviser to open a 529 account - Great plans are available to you directly and you can save a lot of money by opening your own account. 

2. You can invest in any state's 529 plan (and you should explore your options) - Morningstar groups 529 plans from best to worst. I hope your state has a great plan, but look elsewhere if it doesn't. A small tax break (which some states offer for investing locally) does not excuse poor investment options or ridiculous fees.

3. Never, ever, pay a sales charge or load - Paying for the right to invest in a fund is as ridiculous as paying an employer to offer you a job. You'll want to find a plan that offers no-load index funds that charge less than 0.50% in annual expenses (and much less than that, ideally). All fees that are less than 1.0% may seem small, but these tiny differences can add up to a small fortune over time.

A CAUTIONARY TALE (WITH A HAPPY ENDING)

A financial adviser talked my grandfather (a NJ resident) into opening a NJ 529 plan even though the beneficiary (his granddaughter) lived in New York. That adviser pocketed a commission for giving my grandfather terrible financial advice. 

The NJ 529 plan, managed by Franklin Templeton, charged 5.77% up-front, plus 0.50% in annual expenses for managing an S&P 500 index fund. There were no tax benefits for anyone. That bad advice could have cost my family thousands of dollars over time. 

Fortunately, we minimized our losses by transferring the account to New York's 529 College Savings Program Direct Plan. The NY plan has no up front fees, it only charges 0.16% in annual expenses for high-quality Vanguard funds, and it offers tax breaks for New York residents.  

This article is an excerpt from The Best and Worst Investments You Can Make for Your Child, published in full on my website: johnwdefeo.com.

More Articles:

Disclosure: I am/we are long VTI.

Additional disclosure: This article is not personalized financial advice and shouldn't be treated as if it were. I believe that all of the information written above is true and accurate (at the time it was published).