Today parents typically pay their children’s higher education expenses from income and savings. But there are a number of options available to them, including 529 Savings Plans and Coverdell Education Savings Accounts. There are benefits to both options. There are also key differences between the two. How you use these plans depends on your specific college savings requirements and your long-term financial plan. This article compares and contrasts these two popular savings vehicles.
What is a 529 Plan?
A 529 plan is a “qualified tuition plan” sponsored and administered by a state, state agency, or educational institution. They are tax-advantaged accounts to save for future education costs. The owner can allocate funds in the account to different investments that make sense for his or her specific goals and risk tolerance. Funds in the account grow tax deferred.
There are two kinds of 529 plans: College Savings Plans and Prepaid Tuition Plans.
College savings plans are more common. They are also more flexible. They can be used for a broader range of qualified education expenses and have fewer restrictions (e.g., attending out-of-state schools).
By comparison, prepaid tuition plans do not allow funds to be used for ancillary expenses, such as room and board. They are often tied to just one (sponsoring) educational institution and can’t be used at another school.
Withdrawals from a 529 plan are not subject to federal income tax when they are used to pay tuition and fees, books and supplies, and computer equipment and online access. These are all “qualified education expenses”. In some cases, these withdrawals might not subject to state tax either.
Depending on the plan chosen and the state in which it was opened, qualified expenses may also include ancillary expenses. But this is not so in every case.
A 529 account may be opened and contributed to by anyone, including non-family members. Typically, the are opened by parents or grandparents of the beneficiary. The account holder can choose from a variety of investment options, including mutual funds and exchange-traded funds.
There is no federal maximum annual contribution limit. And some states limits can be quite high. However, the account total cannot exceed the amount of money necessary to pay for the beneficiary’s education expenses.
A recent change to how funds in a 529 plan can be used was created by the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Now, up to $10,000 can be used to pay student loan debt.
Investment options can be limited in a given 529 plan. There is always an element of risk in any investment. There are fees associated with these plans. And there is a federal tax penalty levied on funds used for anything that is not a qualified education expense. That penalty can be quite high.
What is a Coverdell ESA?
Formerly known as an Education IRA, Coverdell Education Savings Accounts (ESA) also offer tax advantages. Calling them IRAs is a misnomer. They are for education expenses, not retirement. And contributions to them are not tax deductible. Still, money contributed to an ESA does enjoy tax deferral on income and growth.
Anyone can set up an ESA for a beneficiary under the age of 18. Funds can be withdrawn tax free when used for qualified education expenses, but withdrawals used for purposes other than qualified education expenses are subject to tax.
There is a $2,000 annual contribution limit, and some high income taxpayers may be precluded from making contributions altogether. Contributions also must stop after a beneficiary reaches age 18. Beneficiaries are entitled to any money remaining in an ESA account on their 18th birthday…even if they do not attend college.
For purposes of FAFSA and EFC, ESAs are considered an asset of the account owner, not the beneficiary. Funds in an ESA can be used for ancillary education costs such as uniforms. Even transportation is covered.
Comparing 529 Plans and Coverdell ESAs
There are a few similarities between these savings vehicles. When to use one over the other will be determined by the investors long-term financial goals. Here is how the two overlap:
- Tax-advantaged savings
- Beneficiaries can be changed
- Funds can be used for some primary and secondary education expenses
- Funds used for nonqualified expenses are subject to tax penalty
There are also a few differences between 529 plans and ESAs. For example:
- Contributions to a 529 plan have high limits
- ESAs have an annual contribution limit of $2,000
- ESAs have greater flexibility to cover primary and secondary education expenses
- ESAs offer more investment flexibility than 529 plans
- Funds in a 529 always remain the account holder’s property
- Money in an ESA passes to the beneficiary at age 18
Choosing Between a 529 Plan and an ESA
While there are many differences between a 529 plan and an ESA, each offers parents (and other contributors, like aunts, uncles, and grandparents) distinct benefits. How an investor uses those different benefits will be determined by his or her specific financial circumstances and overall goals.
That’s why such college savings programs ought to be considered in the context of a more comprehensive financial plan. It is also why the two types of accounts can be used in tandem in an attempt to achieve very specific outcomes.
For example, an ESA by itself may not provide sufficient sums to finance a child’s entire post-secondary education. But an ESA offers greater flexibility over a 529 plan in terms of how funds can be used. So, an account holder might rely on a 529 plan to cover fees and tuitions, and an ESA to finance room and board.
You are not precluded from using one type of plan just because you use the other. You could contribute to an ESA to take advantage of its wider investment opportunities and greater flexibility. At the same time, you might use also a 529 because it offers much higher contribution limits.
Clearly, both have benefits that you may be able to use. What is important is that you look at them holistically. The key is that you not make important planning decisions in the absence of advice. Consult a financial advisor regarding education savings plans. And use our college savings calculator to help inform those conversations.