The costs to go to college have been increasing steadily for the past two decades. From 2001 to 2021, the average cost of tuition has increased 144%. Although in-state schools have traditionally been the most cost-effective option, they have increased in price by upwards of 212% over the past 20 years.
Today, it is a challenge to go to school without incurring significant amounts of debt. Children and parents need to plan carefully if they want to avoid having a student loan hanging over their heads for years to come.
Now, state and federal governments offer a couple of tax-advantageous savings plans that parents can use to start saving early for their children’s college education. They each have their own benefits and drawbacks that you should consider before saving in either an ESA or a 529 plan.
The first 529 Plan was introduced in Michigan in 1986. It was called the “Michigan Education Trust (MET)” at that time. 529 Plans get their name from the IRS code section that allows these funds to be established and gives them certain tax advantages. State governments develop them, and not every state has its own 529 Plan.
At its core, a 529 Plan is a savings account that offers tax-free earnings growth. When you use the funds for qualified education expenses, the withdrawals from the account are tax-free as well.
Examples of qualified education expenses will often include:
Some plans will also allow students to use the funds for room and board as well. The funds can also be used to pay for federal and private student loans.
In 2019, the SECURE Act was passed, which increased the options for qualified expenses for these accounts. You can now also use these funds for apprenticeships and homeschooling expenses.
Money in a 529 plan can also cover some K-12 school expenses too. The payments must specifically be for tuition, and you are limited to no more than $10,000 per year.
The money in a 529 plan is yours, so you can use it for any purpose. However, if you choose to use that money for anything other than qualified education expenses, you will have to pay ordinary income taxes on it, and there is a 10% tax penalty. There are a few exceptions to the tax penalty, but it will be imposed in most situations.
There are two types of 529 plans that you can use.
College Savings Plan.
One option, which is the more traditional option and the most commonly used, functions as a savings account for college expenses. You use after-tax dollars to fund the plan. Those funds are then invested, much like you would in a Roth 401(k) or Roth IRA. The plan’s value can go up or down, depending on how well your investments are doing.
Prepaid Tuition Plan.
The second option allows you to prepay all or part of your tuition expenses for an in-state public college education. They can sometimes be converted for a private college or out-of-state college, but some fees or other costs are associated with that conversion. Individual colleges will often offer prepaid tuition plans, but they cannot offer college savings plans.
Frankly, there are very few disadvantages of a 529 Plan. It has fewer restrictions compared to Education Savings Accounts (ESAs), and it provides a great vehicle to save with tax advantages. Here are a few restrictions that you should know:
ESAs are also sometimes called Coverdell Accounts, after the Congressman that helped establish these funds. Like a 529 plan, an ESA is a savings plan that allows you to save for education expenses. It can be used for elementary and secondary school expenses as well as college costs. It is not sponsored by a state, like a 529 plan, but it functions more like a trust or custodial savings account.
An ESA also allows for tax-free growth in an account, and when you use the funds to pay for qualified education expenses, withdrawals are tax-free as well.
ESAs and 529 Plans are extremely similar, but they have some important differences.
Yes. You can contribute to both an ESA and a 529 plan. However, the combined contribution should be less than $15,000 for an individual or $30,000 for a married couple to avoid having to pay gift taxes.
You cannot rollover funds from a 529 to an ESA. However, you can rollover from an ESA to another ESA or 529 plan, as long as they have the same beneficiary.
If the beneficiary does not use the ESA before they turn 30, the money can be rolled over to another eligible family member. Otherwise, the money will be distributed to the beneficiary when they turn 30, and it will be taxed as income.
Every plan has slightly different requirements and limitations when it comes to contributions. Each state sets the aggregate limit for deposits based on the cost to attend college in that state. California, for example, has the highest aggregate limit of $529,000. Georgia and Mississippi have the lowest limits of $235,000. Colorado’s maximum limit is $400,000.
While they do not have annual plan contribution limitations, those who put funds in the plan should be mindful of gift tax limitations.
Neither plan is necessarily better than the other. Your unique financial situation and your child’s needs will impact which college savings vehicle makes sense to use for your family.
Dechtman Wealth Management can help you make this decision and ensure that your dollars are working hard to save for your child’s education.