MONEY Ask the Expert

Why You Might Want More Than One College Savings Account

Robert A. Di Ieso, Jr.

Q: I have college savings for my children in both education savings accounts (ESAs) and 529s. Is there a difference in the way those accounts are calculated for potential financial aid? Would there be any benefit to consolidating into one type of account? — Mike Spofford, Green Bay, Wisc.

A: The good news: There is no difference in how Coverdell ESAs and 529 savings plans factor into your child’s student aid, says Mark Kantrowitz, publisher of Edvisors.com, a website that helps people plan and pay for college.

Both of these education accounts are considered qualified tuition plans. So as long as they are owned by a student or a parent, the plans are reported as an asset on financial aid forms and have a minimal impact on your aid eligibility (federal aid will be reduced by no more than 5.64% of the value of the account). What’s more, your account distributions are not considered income, Kantrowitz adds.

Education savings accounts and 529s share other appealing features: Your savings grows tax-deferred and withdrawals are tax free as long as the money goes toward qualified education expenses. If you spend it on anything else, you will be hit by income taxes on the earnings as well as a 10% penalty.

One of the biggest differences is how much you can put in. ESA contributions max out at $2,000 per child per year, while 529s have no contribution limits. However, if you put more than $14,000 a year into your child’s 529—or $28,000 as a couple—the excess counts against your lifetime gift tax exclusion and must be reported to the IRS. You can get around that by using five-year tax averaging, which treats the gift as if it were made over the next five years.

Coverdell ESAs give you more investment options—from certificates of deposit to individual stocks and bonds to mutual funds and ETFs; you’re usually limited to a small number of mutual funds in a 529 plan. But you don’t need that much investing flexibility, Kantrowitz notes, since you want to keep risks and fees to a minimum over the short time you have to save for college.

Another key difference is that ESA funds can be spent on K-12 expenses; 529s must wait until college. ESAs also come with age restrictions. You can contribute only while the beneficiary is under 18, and to avoid penalties and taxes you must spend the funds by the beneficiary’s 30th birthday (with a 30-day grace period).

You can get around this age limit by changing the beneficiary to an under-18 close relative of the beneficiary. Or you can roll it over into a 529 plan with no tax penalty. (You cannot roll your 529 into a Coverdell ESA, however.) In fact, later-in-life education is one of the only reasons to consolidate plans. Otherwise, says Kantrowitz, there is no compelling reason to combine your two savings accounts into one.

MONEY 529s

What Penalty Will I Pay On Leftover 529 Money?

Q: I recently graduated college and have money left in my 529 plan. I would love to use the funds to help relieve some of my debt. What will the penalty be for withdrawing funds for this purpose? —Stephen, San Francisco

A: You’re right to assume a penalty. While you can withdraw money from a 529 college savings plan tax free for qualified higher-ed expenses like tuition, fees and books, you’ll be dinged if you use the funds for other purposes. You will have to report the amount distributed as taxable income next April—and will therefore owe tax on it at your ordinary rate—plus you’ll pay an additional 10% federal penalty tax on your account’s earnings. (By the way, if for some reason your debt is student loans, you’re not off the hook; the IRS doesn’t consider them a qualified higher education expense.)

There is one out: If you’re a recent graduate—as in, you’ve graduated in the same calendar year as when you plan to make the withdrawal—you can still take out funds tax free for qualified education expenses. So, if you paid out-of-pocket for books your spring semester, and haven’t already taken a 529 distribution to cover that expense, you can withdraw an equal amount from your account anytime during the rest of that year tax free even though you’re no longer a student, says Joe Hurley, founder of SavingforCollege.com and a certified public accountant. Keep in mind that, while you don’t need any evidence to make the withdrawal, “you just need to have proof available in case of an audit.”

If you still have money left in your 529 after that, look at any scholarships you received during your college career, says Hurley. The IRS doesn’t want to punish people for saving up for expected tuition that ended up being paid for with scholarships. So if you can attribute your leftover balance to those scholarships, the 10% penalty on non-qualified distributions is waived. The IRS does not state whether the distribution and scholarship have to occur in the same calendar year when applying for the waiver, but Hurley says most tax experts believe it does not need to match up. He suggests tracking the total amount of scholarship aid you received during college and using that amount to justify having the penalty waived.

Can’t use that workaround? Empty the account now while you’re still likely to be in a lower income tax bracket, says Hurley. If you wait a few more years, you could move up to a higher tax bracket and lose more of those funds to the IRS. Or, if you think you may want to go back to school at some point, your best bet will be to sit on the funds.

MONEY College

Are You Ahead of Your Peers on College Savings?

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Happy 529 Day! Sarina Finkelstein/bravo1954—Getty Images

A new report shows that 529 accounts are growing, but that investors are shying away from stocks.

Americans have a record high college savings level of more than $230 billion, and are adding to that at a rate of about $700 million more every month in 2014, some recent studies have show.

That sounds like a lot of money—until you consider that there are more than 82 million Americans under the age of 20. So overall Americans have saved just $2,800 per youngster, and the average amount set aside annually per kid divides out to just a hair over 100 bucks.

But in a special report issued on May 29 in honor of 529 Day, Morningstar pointed out some hopeful news. At least Americans are paying less to have their college savings invested in 529 plans. The fund companies with the lowest fees now have the biggest market share, Morningstar says.

Plus, competition is forcing most 529 managers to cut their fees, says Kathryn Spica, a senior analyst at Morningstar and author of the report.

Related: College Savings Cheat Sheet: It’s As Easy As 5-2-9

That’s good for investors, since research shows that low-fee funds tend to outperform more expensive competitors over the long term.

“There are a lot of positive signs,” Spica says.

However, Morningstar also found that investors have lately been opting for more conservative investment options. And that’s not a positive for everyone.

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SOURCE: Morningstar

Protecting assets when your children are older—or when stock valuations are high, as they are today—is sensible.

But parents saving for younger children, who thus have many years to ride out stock market corrections, would do better to invest aggressively. As the Morningstar report showed, the average 529 conservative allocation tallied an annual return of 8.4% a year from 2008 through 2013. More aggressive funds have risen faster—about 14.4% a year over the same period.

Related: How much do you need to save for college?

Additionally, in a 2012 paper, Vanguard found that over 18 years, investors who start out aggressively and smoothly taper down their equity holdings are likely to end up with significantly higher college savings. (See especially Fig. 4.) Investing $1,000 a year aggressively early on results in an average balance of $40,000 after 18 years, versus $27,000 for conservative investors.

James Dahle, a Salt Lake City area emergency physician who has started 15 529s—for his three children and 12 nieces and nephews—says that one of the main advantages of 529 plans is that investments can grow tax-free. So investors who put their 529 savings in, say, bonds, which won’t grow very much, lose out on one of the biggest advantages. “The more you earn, the more you save on taxes,” says Dahle, who blogs about his investments at WhiteCoatInvestor.com.

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