Answering Your Top Questions about 529 Plans
Here’s our second guest blog post from Rande Spiegelman, Vice President of Financial Planning for the Schwab Center for Financial Research. Rande will be dropping in from time to time to answer questions, such as these submitted through our Client Connection online community, powered by Communispace. Or, you can check out Rande’s regular commentary in the Market Insight section of schwab.com.
Q: When looking to save for my kids' education should I fund a Coverdell first then a 529 or is it the other way around? When withdrawing funds to pay for education which plan should I draw down first Coverdell or 529? –Tom M.
My preference would be to fund the Coverdell first, up to the limit insofar as you’re eligible. Then, if you can save more go ahead and fund the 529 to the extent you’re able (you can contribute to both in the same year). With a Coverdell, you’ll generally have more flexibility with respect to investment choices and can withdraw the money tax-free for qualified K-12 expenses as well as college. Otherwise, the two accounts are very similar. For more, see College Planning on schwab.com.
Q: With 2 kids in middle school I am struggling with the tax code issues on youth dividends. How do you suggest using qualified education accounts and taxable accounts to grow but still protect the amounts available when converted to cash in the years immediately before college?... How should a parent consider qualified and taxable accounts, meaning what types of assets to put in each, as you get closer to cashing out the investments? Most would argue that, in an oversimplification when accumulating assets, you should put anything paying income in the tax deferred account and volatile assets like emerging market stocks in the taxable account. But during the payout phase some argue the opposite, so there needs to be a transition period… When do you start to transition to the payout phase with college accounts? Does it matter how much is in them, or how much wealth the parents have, or where the markets are at currently? –Max R.
You can contribute up to $2,000 per year to a Coverdell account, if you’re eligible, and 529 plans generally have lifetime contribution limits well in excess of $200,000. If you’re able to save even more than these two plans allow combined, congratulations!
Investments in taxable custodial accounts are subject to the Kiddie Tax rules, which could offer some minor income tax benefits for the first $1,900 or so of investment income (anything over the annual limit is taxed as the parent's rate). In any event, when you have both taxable and tax-advantaged accounts, it’s generally a good idea to put the most tax-efficient investments in the taxable account. Typically, that means stocks and stock funds that generate long-term capital gains and qualified dividends. Broad-based stock index funds and ETFs generally fit the bill. That doesn’t mean you wouldn’t use similar types of investments in your tax-advantaged accounts, but to the extent you’re going to include fixed income or securities that generate investment income taxed at higher ordinary rates, tax-advantaged accounts would be the first choice.
Remember you have one overall portfolio potentially consisting of many account types. So, don’t lose sight of your overall asset allocation as you implement between accounts. For more, see my Market Insight article on schwab.com, The Importance of Tax-Efficient Investing.
This information is for general informational purposes only and is not intended as an individualized recommendation or a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends that you consult with a qualified tax advisor, CPA, financial planner, or investment manager.
All expressions of opinion are subject to change without notice in reaction to shifting markets, as well as tax and estate planning rules.
Investing involves risk, including possible loss of principal.