Saving money for your children’s future education is on the minds of many parents. With college costs continuing their rise in prices, it is a wise move to start this process as early as possible. Though there are some key differences, both 529 plans and Coverdell ESAs offer tax advantages for those looking to save for their children’s college costs. It is important to understand how they compare and contrast in order to decide if either of these is suitable for you.
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The act of saving for college is a cornerstone of personal finance for many. This holds true regardless of the type of savings account you elect to use.
What Is a Tax-Advantaged Savings Account?
The U.S. government views putting money aside for certain needs as a societal good and, therefore, offers tax incentives to do so. There are investment accounts that are designed to encourage individuals to save for retirement (401(k) plans and IRAs), healthcare costs (HSAs and FSAs), and higher education.
Though each savings vehicle has its own unique function and identity, these share the common denominator of using tax incentives to promote greater savings for specific purposes. In other words, by opening these accounts (or having your employer do so on your behalf), you can decrease your tax burdens as long as you agree to abide by certain rules and criteria.
Some of these tax burdens will allow you to decrease your tax liabilities for the year in which you make a contribution, as is the case with traditional 401(k) plans and traditional IRAs. For others, the tax benefits will be on the other side of the equation when you withdraw your funds (Roth retirement accounts, Coverdell ESAs, and 529 plans).
What Are 529 Plans?
529s–also known as Qualified Tuition Programs–are investment vehicles that were created to encourage savings for college. Every state other than Wyoming offers a 529 plan, either through a state agency or a brokerage that the state has enlisted.
Upon opening a 529, you will designate a beneficiary and begin making contributions. The contributions to 529s are made with after-tax income, which can then be invested into assets and grow tax-free. Therefore, the profits you make through the years via these investments can be withdrawn and spent tax-free, assuming they are used to pay for qualified educational expenses.
These qualified expenses extend well beyond simply paying for tuition at four-year colleges. Qualified expenses can also include K-12 tuition, tuition at trade schools, certain apprenticeships that are registered with the U.S. Department of Labor, some gap year programs, and studying at qualified international universities. The funds in your child’s 529 can also go towards room and board, books, computers, and up to $10,000 worth of student loan repayments.
What Are Coverdell ESAs?
Similar to 529 plans, contributions to Coverdell ESAs are made with after-tax income. The money you place in your Coverdell ESA is invested and will grow tax-free. Assuming the funds are put towards qualified educational expenses, they can also be withdrawn and used tax-free.
These qualified expenses can be traditional costs such as tuition, fees, books, and housing, but they can also extend to other educational needs such as student activity fees, supplies, and even transportation to and from school. Coverdell ESAs also allow you to use these funds for other types of K-12 expenses, not just tuition, as is the case with 529 plans.
You can open a Coverdell ESA at brokerages that offer this service, at which time you will designate a beneficiary. Once open, you will direct these funds into various investment vehicles that your chosen brokerage offers.
Which Is Right for You?
There is significant overlap between Coverdell ESAs and 529 plans, though there are also some key differences between the two.
(1) Income limits: There are no income restrictions for 529 plans. However, only those making modified adjusted gross income under a certain amount can make full contributions to Coverdell ESAs. This is currently $190,000 for joint filers and $95,000 for single filers. Joint filers making up to $220,000 can make reduced contributions; those earning over $220,000 cannot make any contributions.
(2) Age limits: Coverdell ESAs must be either spent, transferred to another beneficiary, or closed once the beneficiary turns 30. There are no age restrictions for 529 plans, and beneficiaries can use them for educational expenses throughout their lifetimes.
(3) Annual contributions: Each beneficiary can only receive up to $2,000 per year in annual contributions for Coverdell ESAs. There are no annual contribution limits for 529 plans, though there are limits on the maximum amount that can be placed in a 529 plan, which vary by state.
(4) Qualified expenses: Coverdell ESAs tend to allow for more flexibility regarding what qualifies as an educational expense. For instance, only $10,000 worth of tuition costs at K-12 institutions can be paid for with funds from 529 plans, but not other expenses related to K-12 schooling. Coverdell ESAs allow for additional K-12 costs, including tutoring and special needs services.
(5) Tax deductions: Contributions to Coverdell ESAs are not tax deductible. Depending on the state and your residency status, you may be able to receive state income deductions on your 529 plan contributions.
Conclusion: Saving for the Future
Saving for the future is always a smart financial move. There are certain costs that you can reasonably anticipate, such as your children’s educational needs.
Both Coverdell ESAs and 529 plans can help you put money aside, and not simply because they offer tax advantages. Creating these accounts can make channeling money into these funds an automatic part of your budget. It can therefore become natural for you to become accustomed to contributing to these savings on a regular basis.
Whether you decide to go with a Coverdell ESA, a 529, or a regular savings account at your bank or credit union, making an intentional decision to save will allow you to gradually grow your funds over time. These can be used for education, retirement, or healthcare related costs, or really any other future purpose that you desire.
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