Compare 529 plans and Coverdell

As the parents of a newborn baby, toddler or school-age child, you may be wondering which education savings plan is the best for you and your family. Today, parents have a choice between three tax-free plans for their children: a Coverdell education savings account, a prepaid tuition plan or a 529 savings plan.

If your children's grandparents are in a financial position to help fund your children's education, they can contribute to an account you set up, or they can set up their own account. In either case, funds saved in grandparent-owned 529s may not be considered when you file the Free Application for Federal Student Aid, or FAFSA.

There are five major factors to consider before making your selection. You need to look at the tax benefit, the financial aid impact, can the account can be rolled over, tax consequences and student loan implications.

Comparing college savings plans

	529 savings plan	Prepaid tuition plan	Coverdell education savings account
Uses	Higher education	Higher education	K-12 and higher education
Tax benefit	Earnings grow tax free	Earnings grow tax free	Earnings grow tax free
Withdrawals	Tax free as long as money is used for higher education	Tax free as long as the money is used for higher education	Tax free if they do not exceed the beneficiary's qualified education expenses for the tax year
Who owns account?	Asset of account owner	Asset of account owner	Asset of account owner
Financial aid impact	Parents expected to contribute 5.64 percent of the money toward college expenses annually	Parents expected to contribute 5.64 percent of the money toward college expenses annually	Reduces child's eligibility for federal student aid by a maximum 5.64 percent of the value at the time of application
Rollover status	Can be transferred tax free to the 529 plan of a family member	Can be transferred tax free to the prepaid tuition plan of a family member	Can be transferred into a Coverdell account for a family member
Tax consequences	Contributions qualify for the $12,000 annual gift-tax exclusion Contributions between $12,000 and $60,000 can be spread over five years	Exempt from federal income tax and often exempt from state and local taxes	No tax consequences if new beneficiary is under the age of 30. If money is not used for education, earnings subject to tax and penalty.

Some caveats
Coverdell accounts have a maximum of $2,000 per beneficiary from all sources per year with contributions until age 18. All money must be withdrawn from this account by time the beneficiary reaches the age of 30 and distributed within 30 days or the earnings will be taxes as ordinary income plus a 10 percent penalty.

529 plans generally have no restrictions on contributions (gift-tax rules apply). The income level of a donor may affect contributions to a Coverdell education savings account, but does not affect contributions to a 529 plan.

The need-based financial aid treatment of family assets is determined by whether the assets are owned by the student or the parents. A formula assesses a percentage of student assets and a percentage of parental assets. Student assets are assessed at a flat rate of 20 percent (effective July 1, 2007). Parental assets are assessed on a bracketed scale with a maximum rate of 5.64 percent. However, parental assets are partially sheltered by an asset protection allowance based on the age of older parents (may be approximately $45,000). Retirement plans, the net market value of the parents' primary home and small businesses owned and operated by the family are also sheltered.

The Higher Education Reconciliation Act of 2005 changed the financial aid treatment of prepaid tuition plans. Previously, the distributions reduced need-based financial aid dollar-for-dollar (100 percent). Effective July 1, 2006, prepaid tuition plans have the same financial aid treatment as 529 college savings plans -- they are treated as an asset and the reduction in financial aid will be only 5.64 percent of the payout of the prepaid account.

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