Plan ahead with a 529 or Education Savings Account to jumpstart your child’s career.

ELI5

Paying for higher education can be a substantial cost for a family – and many times it’s the most significant cost after purchasing a house. A majority of families will utilize student loans to help pay for their child’s college and/or university costs. To help reduce the size of the student loan burden on you or your child, it’s best to prepare and stay ahead of the curve by investing money well before they step onto a college campus.

The two major ways to effectively save for education are – a 529 plan or a Coverdell Education Savings Account (ESA). Which one should you use to prepare for your child’s secondary and higher education costs?

Detailed Definition

529 Plan

A 529 plan is a tax-free, education savings plan that is sponsored by most states. There are two main types of 529 accounts – prepaid tuition and college savings plans.

Prepaid tuition plans allow individuals to purchase units or credits at colleges and universities at the current time (locking in lower prices). Prepaid tuition plans specifically only cover tuition and not room & boarding fees. Since you are purchasing credits at today’s dollar value, you are protecting yourself against inflation. Due to this feature, these plans actually don’t let you invest the money. Here’s a list of prepaid tuition plans.

Prepaid tuition plans aren’t as prevalent as the most popular type of 529 plan – the college savings plan. Let’s look at the pros and cons.

College savings plan advantages:

  • Very high contribution limits unlike 401(k) [$19k] & IRA’s [$6k]. You can deposit as up to $380,000/year (will vary state by state) to help the account beneficiary (typically your child or another family member).
  • Contributions are not deductible, but the money can grow and be withdrawn tax-free. Important to realize that only qualified educational expenses are allowed, otherwise you will be penalized.
  • State-sponsored 529 plans can have additional tax breaks.
  • As of 2018, you can also use up to $10,000 towards private or public elementary and secondary schooling.

College savings plan disadvantages:

  • High account fees depending on which 529 plan you choose.
  • Limited investment options unlike IRA. The 529 plan you proceed with has a limited set of investment selections which can deter some financially savvy plan owners.

Here’s a list of college savings plans.

Coverdell Education Savings Account (aka ESA)

ESA’s are the main alternative to a 529 plan, and they come with their own set of pros and cons. One thing to note is, similar to an IRA & 401(k), you have the option to use both and can be strategic about allocating your money between a 529 plan and ESA.

Funds in an ESA can be withdrawn for more than solely tuition expenses and can go towards a broader category of schooling costs including course materials and on-campus activity fees. In addition, ESAs can be spent towards almost all forms of schooling including public or private primary, middle, secondary, and higher education.

ESA advantages are:

  • Funds in the account can be used towards a more general list of qualified expenses.
  • Contributions are not deductible, but the money can grow and be withdrawn tax-free. Important to realize that only qualified educational expenses are allowed, otherwise you will be penalized.
  • Flexible investment options, similar to a Roth IRA. Better suited for the financially savvy investor.

ESA disadvantages are:

  • Unlike the 529 plan, there is a contribution limit of $2k/per beneficiary. The contributor will be penalized with a 6% excise tax if this amount is exceeded.
  • Income eligibility requirements based on MAGI (modified adjusted gross income). For a single filer with a MAGI between $95K-$110K or a married couple with a MAGI between $190K-$220K – the $2k limit decreases.