As the cost of a college education becomes increasingly expensive with each passing year, it’s imperative now more than ever to start saving money for your child or grandchild’s future schooling. But which account is right for your family? Here’s a look at the two most popular options: Coverdell Education Savings Accounts and 529 savings plans. While both investment vehicles have tax advantages, they have some major differences you should know about.
Differences in investment flexibility
State-sponsored 529 plans were specifically established through federal IRS regulations to allow you to invest money for future education expenses in a tax-free account. How those investments are allocated in a 529 plan are very limited.
“The 529 savings plan allows you to choose a predetermined investing portfolio that you can use to grow money for your child’s future educational expenses,” explains the team at Ramsey Solutions. “You can reallocate the money within the portfolio you choose, but only twice a year.”
An ESA offers far more flexibility, as you can allocate the funds to practically any kind of investment — including stocks, bonds, and mutual funds of your choosing.
Differences in eligibility qualifications
Coverdell ESAs are basically trusts or custodial accounts, and they are only available to households with low or moderate incomes. Looking at gross adjusted annual income, a single-parent filer can make no more than $110,000 per year, while a married couple filing jointly must make less than $220,000 per year.
If your annual household income exceeds those amounts, you won’t be able to open an ESA and should instead opt for a 529 account, as a 529 has no income restrictions.
Differences in contribution restrictions
ESAs are bound by tighter restrictions when it comes to adding money to the account — particularly when and how much. The maximum you can add to an ESA in a given year is $2,000 per child. In contrast, 529 contribution limits are typically much higher. They vary from state to state but often well exceed that small amount.
That means you could easily have triple the amount of money in a 529 by the time your student is ready for college than if you’d invested that money in an ESA. Just keep in mind = you must pay a federal “gift tax” if you contribute more than a certain amount of money to a 529 plan within a single year.
Another restriction that only applies to ESAs has to do with when the funds are added. As long as you follow the other rules pertaining to a 529 plan, you can add money at any time. However, all ESA contributions must be made before the student turns 18 years old. After that point, the account can only be used for distributions or rollovers.
Differences in qualified expenses and usage
Both ESAs and 529 funds can be utilized to pay for qualifying educational expenses at elementary and secondary schools, as well as postsecondary opportunities like college and vocational schools. Here’s where they differ: Because of the SECURE Act of 2019, you can now spend 529 funds on student loan repayment, homeschool expenses, and apprenticeships.
There’s also a cap on the distribution of ESA funds based on the student’s age. All funds must be used before they turn 30 to remain tax-exempt. Otherwise, they’ll be subject to taxation or penalties. 529 plans don’t carry age limits on distributions, so they can be used by adults returning to school at any age.
Otherwise, 529 plans and ESAs are mostly the same. Both provide great ways for you to save up extra money for your family’s education by utilizing tax advantages.