Parents are often faced with the dilemma of if and how they will help their children pay for higher education when the time comes. With student loan debt heading toward $1.8 trillion and tuition going up, there is little doubt that as time passes, education costs will continue to rise.
As 53 percent of all college costs are paid from parental income and savings, according to Sallie Mae, many parents opt to start as soon as a child is born in order to harness the power of compound interest and invest for long-term growth. But deciding in which manner to do this is no easy feat.
When his son was 1 year old, David Bakke, then 35, elected to try not one college savings vehicle, but two. “When I first started investing for college expenses for my son, I was a newbie,” Bakke says.
“I had done some research on both a 529 plan and a Coverdell Education Savings Account, but decided to give both a try — to actually use an investment product to find out if it’s right for [me], rather than just relying on research,” Bakke adds.
So let’s take a look at how these popular education savings vehicles work, and the difference between them.
What is a 529 Plan?
A 529 plan is a tax-advantaged savings plan for future education costs. Funds contributed to the account are invested and grow tax-free over time.
Also defined as a “qualified tuition plan,” 529 plans are sponsored (the account is managed and rules and limits are decided) by a state, state agency, or educational institution.
There are two kinds of 529 plans: a college savings plan and a prepaid tuition plan. The former is the more common and flexible plan, with a broader range of qualified expenses and few restrictions on out-of-state school attendance. The latter does not allow cover for room and board.
When the money in a 529 account is used for qualified educational expenses such as tuition and fees, books, computer equipment and access, the respective withdrawals are not subject to federal income taxes, and in many cases, not subject to state taxation either.
Depending on the plan chosen and the state in which it is opened, qualified expenses may not include room and board (as mentioned above).
These accounts are commonly opened by parents or grandparents of the beneficiary — the child or grandchild who will pursue higher education in the future — but a 529 account can be opened and contributed to by anyone, including non-family members.
These college savings plans act like investment portfolios.
There is no maximum annual account contributions — however, the account total cannot exceed the amount necessary to pay for the higher-level education expenses of the intended beneficiary. While some states do have a contribution limit, it is usually high enough not to be a cause for concern.
Pros of a 529 Plan
- The account can be set up and contributed to by anyone — the account holder can also be the beneficiary.
- The account owner always has control of the funds.
- The account enjoys tax-deferred growth and grows as an investment over time.
- Contributions are typically higher than that of the Coverdell Education Savings Account.
- For tax and estate planning, $15,000 per individual and $30,000 per married couple may be contributed tax-free.
- The Setting Every Community Up for Retirement Enhancement (SECURE) Act enabled the usage of 529 plan funds to be used toward student loan debt of up to $10,000.
- Prepaid tuition plans do not guarantee tuition rates at a particular educational institution.
- There is an element of risk as with any investment.
- There are limited investment options for the investor.
- There are many fees associated with the plan, which can erode investment returns.
- A 10 percent federal tax penalty applies if the funds are used for nonqualified expenses.
- The college savings account can use no more than $10,000 toward elementary or secondary school tuition or fees
What is a Coverdell ESA?
Formerly known as the Education Individual Retirement Account (IRA), the Coverdell Education Savings Account (ESA) is similar to the 529 plan, but with some key differences. It is also a tax-advantaged investment account.
While often still referred to as an IRA, the funds in the account are for education expenses, not retirement.
As with a Roth IRA, nondeductible contributions are made to a designated investment trust account that grows tax-free. There are strict requirements on withdrawals from an ESA that do not apply to 529 plans.
Anyone can set up a Coverdell ESA for a beneficiary of their choice, as long as the beneficiary is under 18, same as with a 529 plan. The funds within this account can be withdrawn tax-free for any qualified educational purposes across all levels — whether elementary or third-level education.
There is a $2,000 yearly limit to contributions for an ESA, much lower than that of the limitless 529 plan, but the account holder has more control over how that money is invested, and is not limited to one state.
However, if the account holder’s modified adjusted gross income is over the limit ($95,000 for single filers, $190,000 for joint) set for a given tax year, they can’t make contributions to the ESA; also, contributions can not be made after the beneficiary turns 18 years old.
Finally, unlike with a 529 plan, the ESA funds must go to the beneficiary at some point, even if they do not attend college — however in the case of financial aid, the account is still seen as an asset of the account owner regardless of this stipulation.
Pros of a Coverdell ESA
- The funds can be used across all levels of education, not just post-secondary.
- The account owner has more control over how the funds are invested than with a 529 plan.
- ESAs can cover ancillary education costs like uniforms, transportation, and tutoring.
- Contributions grow tax-deferred and can be used tax-free for education expenses.
- Funds can be rolled over into a 529 plan as long as the beneficiary is the same, but this can be done only once a year.
Cons of a Coverdell ESA
- There are income limitations for contributors.
- Funds must be distributed to the beneficiary by age 30 or the account owner will face penalties.
- There are no state tax benefits unlike with a 529 plan.
- Contributions cannot be made after the beneficiary turns 18.
The Bottom Line
With $6,000 in an ESA and over $25,000 in a 529 plan, Bakke, now 48, recently stopped making contributions to the former in favor of the latter.
“Overall, I was more impressed by the 529. It has more options, fewer restrictions, and I’ve automated my contributions over the years, which is also helpful. I stopped my Coverdell contributions, basically because of maximum contribution limits. I was not upset with the program; it just had its limitations,” Bakke says.
In short, Coverdell plans provide more flexibility to the account holder in terms of how the funds can be used, but restrict contribution sizes more so (as well as imposing income limitations).
Whether the lack of a contribution limit of a 529 plan is appealing, or the steady $2,000 a year for the Coverdell ESA sounds better, it is important to weigh options to decide which vehicle works best for the investor’s goals and situation.
“Overall, the College Savings Plan provides more flexibility in my opinion since it does not have age restrictions and the contribution limits are very high,” says certified financial planner for Victory Capital, Carlos Valadez. “Distributions can be used in the same manner as the Coverdell.”
Bear in mind that it is not possible to save for a child’s entire private post-secondary education using an ESA alone — nor for the entirety of many state schools. It may make sense to contribute to both accounts, as Bakke did, and eventually settle on one.
As always, the would-be investor should consult with a financial advisor and ensure they are maximizing the funds to their full potential.