Face it: College is expensive. Luckily, when it comes to saving for college, you have numerous possible choices. Two of the most well-known savings programs that offer tax benefits are the 529 plan and the Coverdell education savings account (ESA) plan. While both offer tax-free earnings when you withdraw money to use for education expenses, they do differ slightly, so it’s best to know which one will work better for your family’s needs.
What Is a 529 Plan?
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The 529 plan originated from the IRS and is so named after its section of the IRS code. A 529 plan is a tax-advantaged investment account intended to encourage saving for future higher education expenses for a designated beneficiary. Earnings in 529 plans grow tax-free, and any withdrawals used as qualified expenses at eligible institutions are tax-free at the federal level and at the state level in most states.
Each state has a plan, and those plans vary depending on the state. However, you aren’t required to use your state’s plan, so shop around to see if other plans have lower fees or better investment options.
Within the 529 plan, there are two types of plans, college savings plans and prepaid tuition plans.
College Savings Plans
The savings plan allows you to select a predetermined investing portfolio to grow money for the educational expenses. With this option, you can reallocate the money within your chosen portfolio, but you can only do so twice annually.
Prepaid Tuition Plans
The prepaid plan, on the other hand, locks in the current rate of tuition when the child is born, letting them avoid the massive increase in tuition due to inflation by the time they go off to college 18 years later.
Most people opt for the 529 savings plan because, in the long run, they’ll likely receive a better return on their invested money than they would by locking in a tuition rate with the prepaid plan.
What Is an ESA Plan?
Known as the Coverdell education savings account and named after the late Senator Paul Coverdell, this plan is similar to a 529 plan, but it resembles more of a 401(k) when it comes to investment choices. You can decide to invest money in particular stocks, bonds, or mutual funds, which gives you more say in where your money is allocated. On the other hand, this type of plan doesn’t qualify for state tax benefits like many 529 plans do, although it does qualify for federal tax benefits.
How Do You Choose the Best Option?
Both 529 and ESA plans let your money grow, giving you the possibility of accruing interest instead of having your money just sitting there. They also both allow you to take advantage of compound interest so that your money can potentially outgrow inflation. For instance, if you invest the maximum of $2,000 annually into an ESA, you’ll put in a total of $36,000 by the time your child graduates high school at age 18. However, since you’ve invested money, you’ll end up with more money. If the money earns 8% compound interest over those 18 years, you’ll end up with more than $80,000 for college.
Another common factor is that you can use the money for non-educational expenses. Although this is true, keep in mind that any non-qualified withdrawals are taxed and hit with a 10% penalty. The person who takes out the money pays the tax. You can also transfer the account to another member of the beneficiary’s family, which can come in handy if the beneficiary earns a full ride and doesn’t need the money for schooling.
So how do you know which one is best for you? The easiest way to determine which plan is better for you is to look at the main similarities and differences so you can make an informed decision.
Pros of the 529 Plan
- No contribution limits. You’re not stymied by limits to the amount of money you can contribute annually. However, if you contribute more than $15,000, you must pay a federal gift tax. Also, depending on the state, the maximum total contribution amount you can make is between $200,000 and $500,000, depending on the state.
- No income restrictions. No matter how much money you earn, you can still contribute.
- No age limit for distributions. This applies to most states, so if your middle-aged child decides to go back to school, the funds can come from a 529 plan.
Cons of the 529 Plan
- Limited refund amounts. With most prepaid plans, if your child opts to not attend college, the state will likely only refund the principal and not any interest you’ve accrued.
- Limited investment options. When you invest money into this type of account, you must choose from a menu of investment options found within the plan. Those options depend upon the state’s offerings.
Pros of the ESA Plan
- You can choose almost any type of investment. To help you meet your investing goals, you can choose from among a variety of investments, including mutual funds, bonds, and stocks.
- You can use the money for schooling other than college. You can decide to use the money for primary and secondary schools in addition to college. So if you’re enrolling your children in private, independent, or parochial schools, money can be used for those fees.
Cons of the ESA Plan
- It has a contribution limit. Unlike the 529 plan, which has virtually no limit, the ESA plan has a maximum yearly contribution of $2,000 per child. You also cannot add any more money once the beneficiary turns 18 years old.
- It has income restrictions. You cannot contribute to an ESA plan if you make more than $110,000 as a single filer or $220,000 as a married couple filing jointly.
- It must be used by age 30. The beneficiary must use the funds by age 30 or give that money to another family member to use for educational services. Failing to do so can result in additional taxes and penalties.
- It doesn’t qualify for state tax benefits. If you live in a state that offers deductions for 529 contributions, this can make a huge difference.
If you have further questions about either educational savings plan, reach out to the team of experts at Hawaii Partners 3D Wealth Advisors. We offer investors and retirees of Honolulu, HI, and the surrounding communities, an alternative source for financial and investment advice. We strive to simplify our clients’ lives by giving them comprehensive financial strategies based in our tried and true wealth management philosophy. Even if you have an idea about which plan you want, contact us for a second opinion. Our independent, fee-only fiduciary advisors are more than happy to go over your portfolio at no cost and no obligation to you!