Introduction
We have all seen the headlines of the rampant student loan crisis, and perhaps experience it as well. Everyday teenagers and young adults sign up for a massive loan to cover educational costs. These ever-rising costs and uncertain economic future should be all the encouragement one needs to start saving for school now. When parents or prospective students look for education savings account options, there are two popular options that typically come to mind, the 529 and the Coverdell Education Savings plan (ESA). Either of these options can be very beneficial for future students but there are some differences and nuances any potential investor should be aware of before making the decision as to which investment vehicle to utilize. Let’s step through some high-level information about the two then make some direct comparisons which should provide enough understanding as to which accounts will be more beneficial in which situations.
The 529 Plan
Let’s first take a look at the 529 plan. A 529 plan is a state-sponsored, tax-advantaged savings plan designed to help families save for future education costs, typically used for higher education. Each state sponsors at least one 529 plan. With that in mind, a beneficiary can take advantage of any state’s 529, regardless of state residency.
There are actually two types of 529 plans. The first, which we will not go to in-depth on, is the prepaid plan. A prepaid 529 plan locks in the current tuition rate to avoid a large inflationary price increase by the time a child goes to college. There are only 10 states that currently offer a prepaid plan. As the prepaid plan is designed to match the increase of inflation, prospective students can typically get a significantly better return by utilizing the other 529 plan option, the 529 savings plan.
529 savings plans work like how a Roth 401(k) would work, but for education as opposed to retirement. These plans utilize after-tax contributions, which are then invested in a limited variety of investment options offered within the plan. The investment options allow beneficiaries to reap the rewards of investing in stocks and bonds. When it is time to pay for qualified expenses, direct the program administrator to distribute the required funds to the beneficiary. Qualified expenses include tuition, fees, books, and supplies for higher education. Additionally, the 2019 SECURE Act broadened qualified expenses to include included apprenticeships, private K-12 tuition and fees, and up to $10,000 towards student loans. Anything that does not meet the qualified expense would be subject to taxes and a 10% penalty upon withdrawal. There is no income limit or annual limit on contributions to the 529, but contributors must be aware that anything over the gift limit will be subject to the federal ‘gift tax’ – this limit is $17,000 for 2023. Another important feature of the 529 savings plan in most states is there is no age limit for distributions, making it a great plan for somebody older looking to go back to school or get a higher education degree. Finally, as part of the SECURE 2.0 Act, up to $35,000 in leftover 529 funds are able to be rolled over to a Roth IRA – within the annual contribution limits. This is an incredible feature that limits the taxes and penalties imposed on beneficiaries who might decide to go to a cheaper school, get scholarships, or not go to school at all. This really ensures that the money will be utilized and there is much less concern of over-funding your education account.
The 529 savings plan is a great option. For additional information and research on specific offered plans, our friends at Saving for College have put together a great tool to find a plan that works for any prospective student.
Education Savings Accounts (ESAs)
Much like the 529 plan, an ESA is designed to be a tax-advantage investment tool for those looking to save and invest for education. As we compared the 529 to a Roth 401(k), the ESA is more like a Roth IRA. Investors have a lower annual contribution limit but gain the freedom to manage their portfolios by purchasing a much greater variety of stocks, Exchange Traded Funds (ETF) or mutual funds. The contributions for an ESA are limited to $2,000 annually. Similarly, to a Roth IRA, there are annual income limits. For 2023, it is a gradual phase-out scale from $95,000-$110,000 for single filers or $190,000-$220,000 for those filing jointly. The contributions and earnings within an ESA can be used for college tuition and expenses and can also be put towards tuition and expenses for those in K-12. Remember, the K-12 expenses (books, supplies, etc.) are not covered under the 529 plan.
529 vs ESA Comparison table
Recommendation
Both 529 plans and ESAs offer valuable tax advantages to help you save for educational expenses. Consider your educational goals, contribution capacity, and investment preferences when deciding which account aligns better with your needs. Regardless of your choice, starting early and consistent contributions are key to successfully building wealth for your child's education. As with most things in personal finance, choosing between a 529 plan and an ESA depends on your specific goals and circumstances. That said, the rule changes and features for the 529 in the past few years has really made the 529 savings plan the better option for most investors. By including K-12 tuition/fees and the 529 rollover to Roth IRA feature, in most cases, the 529 will be the superior option. As a bonus, the 529 has a much higher contribution limit and less limitation on the age to utilize the money within the plan. There are instances where the ESA could be a better option, but nobody is going to go wrong by investing within a 529 and ensuring their future students get a head start on paying for school and avoiding at least some of the exorbitant student loans we are seeing in today’s day and age.
