529 Plan vs. Coverdell Education Savings Account (ESA): Which Is Better For Future Education Expenses?
Saving to help put your kids through college is an enormous task.
However, putting off saving for your child’s future college education is the worst thing you can do. It'll also help your child minimize student loan debt.
One way to get even more bang for each dollar you save is taking advantage of tax breaks for saving for college.
You can use 529 plans and Coverdell Education Savings Accounts (ESAs), both of which offer tax breaks you can use to help grow your account faster than you otherwise could.
Learn how they work, their advantages and disadvantages, and which one you should use.
What is a 529?
A 529 plan can actually come in two major forms. 529 college savings plans allow you to save or invest money today for future education expenses.
Then, you use the balance you build to pay for education expenses in the future.
Alternatively, 529 prepaid plans allow you to prepay for future in-state college tuition at today’s rates.
You’re pre-purchasing college tuition in chunks as you can afford to do so.
Each state runs their own 529 plans.
They may offer college savings plans, prepaid plans or both. Most states offer college savings plans, but only a few offer prepaid plans.
Contrary to what you’d think, you don’t have to contribute to a 529 college savings plan just because you live in that state or your child plans to attend college in that state.
Instead, you can generally contribute to any state’s program you wish.
However, 529 prepaid plans may require you to be a state resident to contribute to that state’s prepaid plan.
Tax Advantages of 529 Plans
Even though there are different forms of 529 plans, their federal tax advantages are the same.
A traditional investment or savings account would tax you on the gains or interest you earn. 529 plans do not as long as the distributions are used for a qualified purpose.
Currently, qualified costs include distributions to pay for:
- K-12 tuition up to $10,000 per beneficiary per year
- College-related expenses for eligible schools including
- Approved equipment
- Room and board (as long as the student is attending at least part-time)
State level tax advantages vary by state and 529 plan.
If you live in a state with state income tax, look to see if your state’s 529 plan offers state income tax benefits.
How to Invest Funds in a 529
Once you put money into a 529 savings plan, you have to choose how to invest the money.
Each individual state’s 529 plan will have a list of investment options you can choose from.
The investment options can vary wildly from plan to plan.
It’s important to consider your investment options, fees and other expenses related to a particular state’s 529 plan before you open an account.
Doing so allows you to make an educated decision that gives you the best chance of covering your child’s future education expenses.
529 prepaid plans don’t have an investing option. Instead, you buy a portion of future tuition at today’s rates.
Even if the future price of college increases, your prepaid portions of tuition will still be covered.
Pros of 529s
529 plans are typically considered as a great tool to save for college education expenses.
The money in a 529 plan is considered a parental asset.
This a huge positive as the expected family contribution formula factors in parental assets at a lower percentage than student held assets.
This may give your child a better chance at qualifying for federal financial aid versus having the money in the student’s name.
529 plans are typically flexible, as well. If you don’t end up using the money for your child’s future education expenses, you may be able to transfer the account to someone else that plans to go to college.
Contributing to a 529 plan is a relatively easy process. Anyone can fund a 529 account for an individual.
You don’t have to worry about annual contribution limits, income limitations or age requirements.
Some states do cap the maximum 529 account value.
Cons of 529s
The 529 prepaid tuition plans often come with many requirements regarding residency and which colleges the prepaid tuition can be applied to.
If you don’t attend a college within the 529 plan’s list, your prepaid tuition may not cover the total cost of college elsewhere.
Even 529 savings plans have penalties if you don’t use the funds for qualified education expenses.
You’ll typically have to pay ordinary income taxes on earnings and you may have to pay a 10 percent penalty, as well.
What is a Coverdell Education Savings Account (ESA)?
Coverdell Education Savings Accounts (ESAs) are another way to save for future education expenses.
An ESA is a specific type of account you can open at many different brokerages.
ESAs are trust or custodial accounts for beneficiaries under the age of 18.
Unlike, 529 plans, you don’t have to go through a particular state’s program to open an ESA.
Tax Advantages of ESAs
The tax advantages of ESAs are similar to those of 529s. You can’t deduct contributions to an ESA.
That said, you do get to withdraw the contributions and earnings tax-free if the distributions are less than the beneficiary’s adjusted qualified education expenses for the year.
Expenses can be for elementary, secondary or qualified higher education.
For elementary and secondary education, qualified expenses may include:
- Tuition and fees
- Books, supplies and equipment
- Academic tutoring
- Computer equipment
If the expenses are required or provided by an eligible school, qualified expenses may also include:
- Room and board
- Supplementary items and services
Higher education expenses typically must be required by the school and may need to be incurred by a student that is enrolled at least half-time.
Qualified expenses may include:
- Tuition and fees
- Books, supplies and equipment
- Room and board (with limitations)
- Computer equipment
How to Invest Funds in an ESA
Once you open an ESA account, you can invest the funds you contribute in stocks, bonds, mutual funds, CDs or other investment options.
However, there are certain limitations.
For instance, you can’t invest ESA funds in life insurance contracts.
Just like with 529 plans, your investment options will depend on where you open your ESA account.
Since ESAs can be opened with many brokerage firms, you should have plenty of suitable investment options.
Pros of ESAs
One place where ESAs shine is their investment options.
Since you can choose where you open your ESA, you have more investment options available to you than the state limited investment options in 529 plans.
Like 529s, ESAs are considered parental assets which can help when trying to qualify for financial aid.
In the past, ESAs were a great option to cover elementary and secondary school expenses.
Now that 529 plans can also cover elementary and secondary school expenses, this pro isn’t as strong as it used to be.
Cons of ESAs
Unfortunately, ESAs are much more difficult to use than 529 plans.
Any money in an ESA must be distributed by the time the beneficiary turns age 30.
Distributions of earnings made in excess of qualified expenses for the year will be taxable and result in a 10 percent penalty.
Contributions are limited to a maximum of $2,000 per year per beneficiary. Additionally, you can only contribute to an ESA as long as the beneficiary is under 18.
While multiple people can contribute to or open an ESA for a single beneficiary, all ESAs for that beneficiary cannot exceed more than $2,000 in a single year.
This can require coordination between parents, grandparents, and others that want to help out.
The contribution limit may be even lower if the person contributing to the account has income above the limits set by the IRS.
What to Consider When Choosing Investments
If you decide to use a 529 savings plan or an ESA, you’ll need to decide how to invest the money you contribute to the account.
There are many factors you should consider when deciding which investment to use within a 529 savings plan or ESA.
How much money will you need to fund the education expenses you plan to pay and when will you need it by?
Once you know the answer to this question, it helps make the following decisions easier.
How big of a drop in value can you handle?
Riskier investments tend to have the potential for higher returns, but there is also a larger risk of higher losses if things don’t go well.
You’ll want to choose an investment that doesn’t exceed your risk tolerance so you don’t sell if your investment temporarily declines in value during a normal market cycle.
If you need high returns but can’t handle the higher risk, you should instead focus on finding ways to invest more money so you don’t need as high of a return to meet your goal.
Look at their prospectuses to make sure you’re comfortable putting money in that particular investment.
Also, take a close look at the fees you’ll be charged and try to minimize them to keep more of your investment returns in your 529 savings plan or ESA.
Which Savings Vehicle Should You Use?
529 plans typically offer much more flexibility than ESAs when it comes to contributing and using the money.
However, ESAs allow you to open an account directly with a brokerage firm which can give you access to a wider variety of investments without the limitations of state-run 529 plans.
You should use the college savings vehicle you find best fits your needs.
You can even use both 529 plans and ESAs if you’d like. The important part is picking a plan and getting started.