529 vs. ESA – What You Need to Know

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.

What is 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-deferred earnings growth. When you use the funds for qualified education expenses, the withdrawals from the account are tax-free as well.

What are qualified education expenses for a 529 plan?

Examples of qualified education expenses will often include:

• Tuition
• Fees
• Textbooks
• Supplies
• Computers and other equipment

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.

Types of 529 Plans

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.

The Benefits of Having a 529 Plan

1. Great income tax breaks. The after-tax money you put into this account grows tax-free and is not taxed when you take it out to pay for qualified tuition expenses.
2. Many states offer tax incentives. Over 30 states offer a partial or complete tax deduction or credit for funds you put into a 529 plan.
3. The owner of the account stays in control of the account. Although the money is for a child, the account’s creator still has a say in how the money is used. Conversely, you do not have much control over how the money you hand off to a loved one is spent in a regular savings account.
4. It is very low maintenance. Much like a Roth IRA or Roth 401(k), you generally have to set up a few investing parameters when you set up the account. Then, the plan will operate on its own. It is a hands-off way to save for a college education.
5. Simple tax reporting. Unless your state offers tax incentives, there is no need to report contributions to a 529 plan, which means you do not even need to track how much you are putting into the fund in many situations. However, any contribution to the plan should fall below the gift tax maximums to avoid gift taxes. In 2021, the gift tax limit is $15,000 per individual or $30,000 per married couple.
6. Anyone can use a 529 plan. Coverdell Education Savings Accounts (ESAs) have restrictions on who can use those accounts, but 529 Plans do not have similar restrictions. If you are comparing ESA v. 529, this can be a huge difference in some circumstances.

The Drawbacks of a 529 Plan

Frankly, there are very few disadvantages of a 529 Plan. It has fewer restrictions compared to Education Savings Accounts (ESAs), and we believe it provides a great vehicle to save with tax advantages. Here are a few restrictions that you should know:

• You must use the account for qualified expenses. If you do not use the account for qualified expenses, you must pay regular taxes on the funds’ growth. You may also face a 10% tax penalty as well.
• The investment options are limited. 529 Plans have a pre-set group of investment options. For those that want to be more “hands-on” with their investments, this could be a drawback.
• Fees. Most 529 plans have some kind of maintenance fee attached to them. They vary from plan to plan, but most will include either a flat fee or a percentage fee based on your investments.
• Effect on financial aid eligibility. If a parent owns a 529 plan for their child, that money must be included on the student’s FASFA application. As a result, your child might not qualify for some financial benefits that would be available if you did not save. In some cases, however, this drawback might not be relevant if you save enough to pay for your child’s entire education. Distributions are not counted as income for the following year.

What is a Coverdell Education Savings Account (ESA)?

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-deferred growth in an account, and when you use the funds to pay for qualified education expenses, withdrawals are tax-free.

What is the Difference Between a 529 Plan and an ESA?

ESAs and 529 Plans are extremely similar, but they have some important differences.

• Maximum contributions: A 529 plan allows contributions that can be upwards of six figures per student, but each plan is different. Generally, to avoid gift tax concerns, yearly donations should stay under $15,000 for an individual or $30,000 for a married couple. In an ESA, however, the most you can contribute is $2,000 per year from birth to age 18 ($36,000).
• Investing flexibility: A 529 Plan has pre-selected investment options. In an ESA, you have many options to park your funds.
• Contribution and use restrictions: You can only contribute to an ESA while the child is under the age of 18. The funds must also be used before the child is 30 years old. There are no similar restrictions in a 529 Plan.
• Income restrictions. If your income is over $110,000 filing single or $220,000 filing as a married couple, then you will not be able to contribute to an ESA. A 529 plan does not have any income restrictions.

ESA v. 529: FAQs

Can you have an ESA and a 529?

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.

Can you rollover funds from a 529 Plan to a Coverdell ESA?

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.

What happens to ESA funds if they are not used before the beneficiary is 30 years old?

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.

What is the maximum you can put into a 529 plan?

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.

ESA v. 529: Which is Better?

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.

Disclosures for this blog:
If an account owner or the beneficiary resides in or pays income taxes to a state that offers its own 529 college savings or pre-paid tuition plan (an “In-State Plan”), that state may offer state or local tax benefits. These tax benefits may include deductible contributions, deferral of taxes on earnings and/or tax-free withdrawals. In addition, some states waive or discount fees or offer other benefits for state residents or taxpayers who participate in the In-State Plan. An account owner may be denied any or all state or local tax benefits or expense reductions by investing in another state’s plan (an “Out-of-State Plan”). In addition, an account owner’s state or locality may seek to recover the value of tax benefits (by assessing income or penalty taxes) should an account owner rollover or transfer assets from an In-State Plan to an Out-of-State Plan. While state and local tax consequences and plan expenses are not the only factors to consider when investing in a 529 Plan, they are important to an account owner’s investment return and should be considered when selecting a 529 plan.

Tax laws are complex and are subject to change. This information is based upon current tax rules in effect at the time this was written.

Investments in a 529 Plan are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so an individual may lose money. Investors should review a Program Disclosure Statement, which contains more information on investment options, risks factors, fees and expenses and possible tax consequences. Investors should read the Program Disclosure Statement carefully before investing.

The 529 Plan Program Disclosure contains more information on investment options, risk factors, fees and expenses, and potential tax consequences. Investors can obtain a 529 Plan Program Disclosure from their Financial Advisor and should read it carefully before investing.