24 Nov Tax advantages of paying for college with home equity rather than Coverdell savings

 Q. I have a Coverdell college fund set up for my daughter. Would it be more to my tax advantage to set up a home equity line of credit to pay for her tuition and use the funds in her Coverdell to pay off the loan?

A. There are many ways to pay college bills, and it doesn’t hurt to get creative.But each option should be considered carefully, so we’re glad you asked.

Coverdell accounts are similar to 529 plans in that they grow tax-deferred and if withdrawn for qualified education expenses, the growth of the accounts are tax-free.

But there are some big differences.

“One big difference is that 529s are for college level and above, use whereas Coverdell accounts can be used for education expenses for children before college years,” said Ron Garutti, a certified financial planner with Newroads Financial Group in Clinton.

He said it’s hard to amass large sums of money in Coverdell accounts because annual contributions are capped at $2,000 per year per child. 529 plans have much higher limits annually, and five years of contributions to a 529 can be made in advance, he said.

Plus, income limits can restrict contributions to Coverdell accounts, which 529s do not have income limits for contributors.

“By the letter of the law, you cannot pay home equity debt with Coverdell proceeds,” Garutti said. “You would need to have education expenses in the year you make a withdrawal from a Coverdell to make a qualified withdrawal.”

That qualified withdrawal is how you get the tax benefits.

In the meantime, $100,000 of home equity debt could be tax deductible, and home equity rates are probably more favorable than student loan rates, he said. But then, taking a money against your home’s equity will mean your home would be tied to the debt, which could be concern.

Alan Meckler, a certified financial planner with Cornerstone Financial Group in Succasunna, recommends if you saved the Coverdell money for your child’s education, you should use it for that purpose.

“The only reason to set up a home equity credit line and borrow the money is that if you feel your earnings on the Coverdell account are better than the interest rate you will be paying on the home equity credit line,” he said. “If you itemize deductions, the home equity interest can also be tax deductible.”

He offered this example: If the Coverdell account is earning 7 percent and the home equity rate is 4 percent and you are in a 25 percent tax bracket, then the real cost of borrowing is 3 percent.

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This story was first posted in November 2014.