Several tax-advantaged college savings vehicles are available to help families save for the ever-increasing higher education costs. Two of the most popular methods for saving for college are the 529 College Savings Plan and the Coverdell Educational Savings Account (ESA). Is one of these methods better than the other? How do you choose between the ESA or the 529 savings plan? Let’s take a look.
Similarities Between 529 Plans and Coverdell ESAs
These college savings plans work similarly to Roth IRAs – contributions are non-deductible and grow tax-free. Withdrawals are also tax-free for qualified higher education expenses. 529 Plans and
Coverdell ESAs are viewed the same for financial aid purposes. They are considered the assets of the custodian (the person who opened the account), and withdrawals by the beneficiary are not considered taxable income when used for college expenses.
Both plans can be transferred to another beneficiary without penalties or fees.
Differences Between 529 Plans and Coverdell ESAs
Types of accounts:
- 529 Plan: Two – Prepaid college tuition and savings plan
- ESA: Only one
Control of account:
- 529 Plan: Account holder controls when withdrawals will be made and for what purpose, and can change beneficiaries at will. There are no restrictions regarding when funds must be used.
- ESA: Account holder can change beneficiary at will. If money is not transferred to a new beneficiary or used for higher education costs, then the beneficiary receives the assets when they turn 30 and the account will be assessed taxes and penalties.
Age limit for contributions and withdrawals:
- 529 Plan: None.
- ESA: Must be under 18 to receive contributions, and must use assets before age 30.
Perhaps your choice of college savings plan will be determined by age limitations. Contributions can be made for a beneficiary of any age with the 529 savings plans, while the Coverdell ESA requires beneficiaries to be under 30.
When it comes time to withdraw money from a 529, beneficiaries can be of any age and use the funds throughout their lifetime, provided they are for approved education expenses.
Funds from a Coverdell ESA must be withdrawn and used by the time the beneficiary reaches the age of 30.
Contribution limits:
- 529 Plan: Between $100,000 and $350,000 depending on state
- ESA: $2,000 per year from all sources
Coverdell contribution limits max out at $2,000 per year per beneficiary. If multiple people contribute to the same beneficiary’s Coverdell ESA, a maximum of $2,000 can be received, making coordination and communication essential to avoid taxes or penalties.
There are no annual contribution limitations for 529 College Savings Plans. The amount allowed per plan over the plan’s lifetime varies depending on the state where the 529 is opened but ranges from $100,000 to $365,000.
Income limits for contributors:
- 529 Plan: No income limit.
- ESA: To qualify for the max $2,000 contribution, your AGI must be less than $95,000 for single filers and $190,000 for married couples. More about ESA contribution limits.
Under the 529 plan, it doesn’t matter how much you earn. Everyone can contribute to a 529 plan.
For the full $2,000 contribution to a Coverdell ESA, you need an adjusted gross income (AGI) of less than $95,000 per year for a single tax filer or $190,000 per year for joint filers. Higher-income earners can contribute smaller amounts per year, but if the maximum income limits are reached, they may not contribute to a Coverdell ESA.
State tax deductions or credits for contributions:
- 529 Plan: Yes, depending on the state plan and residency.
- ESA: No.
Uses for plan assets:
- 529 Plan: Higher education only, including four-year colleges, two-year college, trade schools, and vocational schools.
- ESA: Assets can be used for K-12 and higher education.
Perhaps your choice of college savings plan will be determined by age limitations. Contributions can be made for a beneficiary of any age with the 529 savings plans, while the Coverdell ESA requires beneficiaries to be under 30.
When it comes time to withdraw money from a 529, beneficiaries can be of any age and use the funds throughout their lifetime, provided they are for approved education expenses.
Funds from a Coverdell ESA must be withdrawn and used by the time the beneficiary reaches the age of 30.
Tax Advantages and Benefits of College Savings Plans
Neither the Coverdell nor the 529 plan allows federal income tax deductions on contributions, but the 529 plan may allow tax deductions on state income taxes, depending on state laws. Earnings in both plans grow tax-free.
Withdrawals from a Coverdell ESA or 529 plan for qualified expenses can also be taken federal tax-free. Here are some more tax advantages of 529 plans.
Qualified Withdrawals
The Coverdell ESA and 529 plan both have their lists of qualified withdrawals. For Coverdell ESAs, you can use the money for any educational expense from kindergarten to grad school, including tuition, fees, books, computers, internet access for education, transportation to get to school, and private or public school fees.
Money from a 529 plan must be used for higher education expenses at accredited colleges and universities, such as tuition, fees, books, and room and board.
How College Savings Plans Impact Financial Aid
Money in a Coverdell ESA or a 529 plan is considered an asset of the custodian (usually the parent) and not the beneficiary. If a parent holds the Coverdell ESA, it will be included in the parent’s assets. Parental assets are assessed at a lower rate than student assets when calculating financial aid awards, which helps minimize the impact of money in an ESA.
Investment Options
The Coverdell ESA and 529 accounts allow for stocks, bonds, CDs, and mutual fund investment options. With the Coverdell ESA, you can change your investment allocations as frequently. With the 529 plan, you can only change your investment allocations twice yearly. Here is more information about where to open a Coverdell ESA Plan.
Which is Better — Coverdell ESA or 529 Plan?
Overall, the 529 plan is more flexible regarding who can contribute, contribution limits, and ages when beneficiaries can use the funds. It also offers state income tax deductions in some states.
The advantages of a Coverdell ESA include more flexibility for investments (ability to open an account virtually anywhere and change investments at will), and it offers slightly more liberal qualified withdrawal opportunities.
Can’t Decide?
If you’re still not sure which college savings option is the best for you, you can actually contribute to both a Coverdell ESA and a 529 plan. These plans are independent of each other.
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