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Cheers for the 529 (but beware the Coverdell ESA)
by Joe Hurley, founder, Savingforcollege.com
Sunday, August 13th 2006

[Updated March 27, 2008]

The Pension Protection Act of 2006 made permanent the 529 plan upgrades that were part of the 2001 EGTRRA tax law. That particular piece of legislation was the most positive development imaginable for American families saving for college, and solidified the 529's position as the investment of choice for many college savers.

Without the Pension Protection Act, all of EGTRRA's many provisions would still be scheduled to sunset at the end of 2010. But the 529 portion now survives beyond 2010. The item that gets the most attention (deservedly so) is the federal tax-free treatment for 529 withdrawals used for college. But there were several other scheduled changes—relating to rollovers, state-imposed penalties, room and board caps, and the definition of a family member—that we no longer have to wonder about.

Surprisingly, the good news does not extend to the Coverdell education savings account (ESA). It gained nothing from the Pension Protection Act, and the substantial improvements to the ESA made by the 2001 EGTRRA are still set to expire at the end of 2010. Those improvements included raising the annual contribution cap from $500 to $2,000, allowing tax-free withdrawals for elementary and secondary school expenses (the "K-12" provision), and permitting tax-free ESA withdrawals in the same year as a Hope or Lifetime Learning credit.

What does this mean? Well, just as it was before 2002, the ESA in 2011 becomes an anemic and cumbersome investment loaded with tax traps. In most cases, you will elect to pay tax on your ESA withdrawals after 2010 because you will not want to give up a more valuable Hope or Lifetime Learning credit. But reporting the ESA earnings will also negatively impact financial aid eligibility.

Bottom line: If you like the ESA, feel free to continue your contributions, but be aware of these issues. Even if the ESA falls apart after 2010, the law allows you to roll over ESA funds tax-free to a 529 plan at any time. Congress may still decide to save you the trouble by removing the 2010 sunset provision for the Coverdell ESA. But at this point, you should not count on it. The K-12 provision is a political hot potato—most Democrats oppose public school vouchers and anything else that resembles them—with its survival possibly hinging on the upcoming elections.

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