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Analyzing Coverdell ESA vs. 529 Plans

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Back in 2007, I wanted to gift some money to my newborn nephew. Rather than make it a one time thing, I wanted to contribute to it over the years. I am proud to say that the small contributions and the growth of the stock market have him, and his little sister lined up with almost $2000 each. It's one thing to write about how small contributions over this time add up, it is another thing to experience it in person.

I didn't want to gift the money have it be blown on Transformers and bubble gum. I wanted to give them money towards and education. This meant looking into various vehicles such as UGMA & UTMA Custodial Accounts for Minors, Coverdell ESAs, and 529 Plans. I concluded that the 529 Plan was the best fit. Then it was simply a challenge to choose the right 529 plan.

Now it is 7 years later and I have children of my own. My goals are different than they were back then. The laws governing how these investment vehicles work have changed. It's time to give them another review.

When I say the laws governing the investment vehicles, I'm really only talking about Coverdell ESAs. As I understand it some of the benefits were set to expire, but the American Taxpayer Relief Act enacted in January 2013 made them permanent.

Long story short, it seems like 529 Plans are still the most flexible and best vehicle in vast majority of cases. However, Coverdell ESAs have a couple of benefits that may prove beneficial.

In reading this Saving For College article about Coverdell ESAs it almost sounds like there's nothing to like. If you give $2000 and a grandparent gives $1000, it triggers a tax penalty... even if you didn't know about the grandparents gift. Many mutual fund company won't open Coverdell ESAs (the article notes my three favorites all avoid them: Vanguard, T. Rowe Price, and Fidelity). There are no state tax deductions like some offer on 529 Plans. It seems like changing the beneficiary is more difficult with Coverdells as well.

So why would anyone choose a Coverdell? It seems there are two main benefits. The first is that you can hold "alternative" investments in there as you might a self-directed IRA. I'm still learning about self-directed IRAs, but they seem to be extreme rare and potentially dangerous investment vehicles... probably not suitable for 99.9% of investors. The second benefit is that Coverdells can be used for children in K-12, not just for college. Thus it's a way to save some money on private school expenses.

Not many people choose private school, so at first glance it seems like Coverdell ESAs would be useful for very, very few people. However, as I look at it a little deeper, it seems like educational equipment, including computers, could be qualified expenses.

Anyone else have a Coverdell ESA? If so, how do you plan on using them?

Posted on September 17, 2014.

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One Response to “Analyzing Coverdell ESA vs. 529 Plans”

  1. Steve says:

    I have a Coverdell ESA at Sharebuilder (who does offer them) just to keep gifts from my daughter’s grandparents and greatgrandparents separate from my own contributions (the latter of which feels like I’m just donating on my own behalf, for some reason).

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