When it comes to financial planning for the future, educational expense planning often sits near the top of the list—right alongside priorities such as retirement and home purchasing. Whether you’re preparing for your children, your grandchildren, or even the neighborhood kid who mows your lawn every weekend, there are pre-established accounts specifically designed to help with education expenses. In this guide, we’ll explore two of the most common options: the Coverdell Education Savings Account (ESA) and the 529 Plan, which includes both Prepaid Tuition Plans and Education Savings Plans.
To start, let’s take a closer look at the Coverdell ESA.
The Coverdell Education Savings Account, formerly known as the Education IRA, was established in 1997 and renamed in 2002 after former Georgia senator Paul Coverdell. These accounts may be set up as either trust or custodial accounts but must be designated specifically as ESAs—and that designation must be documented in writing. For an account to qualify, the beneficiary must be:
- Under the age of 18 2.
- A special needs beneficiary
One of the first aspects to consider when evaluating a Coverdell ESA is its limitations. Contribution rules and income thresholds can reduce the attractiveness of the plan for some families. For each beneficiary, the maximum contribution limit is $2,000 per year, even if there are multiple ESA accounts for the same individual. Additionally, contributors must fall under certain income caps: $95,000 for single filers and $190,000 for joint filers, based on their adjusted gross income (AGI). Contributions must be made in cash, and since they are made with post-tax dollars, they are not tax-deductible.
Despite these restrictions, ESAs offer several advantages—particularly in terms of qualified educational expenses. One standout feature is the broad range of expenses that qualify for tax-free distributions. Unlike some other savings vehicles, ESAs can be used for both postsecondary and K–12 education. If distributions, including capital gains, are used for qualified expenses, they are exempt from federal taxes.
Another notable benefit is the flexibility in investment options. While ESAs don’t match the breadth of a typical brokerage account, they offer a wider variety of choices than most other education savings plans. If the selected investments aren’t performing as hoped, the ESA allows for self-directed investment changes at any time, which isn’t possible in all competing accounts.
As with any financial product, it’s important to plan for various outcomes. So what happens if the child doesn’t attend college or there are leftover funds in the account? Under ESA rules, funds must be distributed by the time the beneficiary turns 30, unless the beneficiary is classified as a special needs individual. If distributions are used for non-qualified expenses, the amount is added to the beneficiary’s gross income and is also subject to a 10% withdrawal penalty.
Fortunately, there are ways to avoid these taxes and penalties if you no longer need the ESA for the original beneficiary. Two primary alternatives include:
- Roll over the funds for the same beneficiary, tax-free, into a 529 plan. However, it’s important to note that you cannot roll over funds from a 529 plan into an ESA. 2.
- Roll over the funds into an ESA for a qualified family member of the beneficiary. This can only be done once every twelve months per beneficiary.
If, after reviewing the ESA’s features and limitations, it doesn’t seem like the right fit for your financial goals, you may find what you’re looking for in a 529 plan. These plans offer two different approaches to education savings:
- Prepaid Tuition Plan
- College Savings Plan
Though they share some similarities, each plan has key distinctions. We’ll begin with the less commonly used Prepaid Tuition Plan.
A Prepaid Tuition Plan allows families to purchase future tuition at today’s rates, offering a hedge against tuition inflation. These funds then grow at a rate equal to tuition cost increases over time. In essence, the investment “growth” matches the cost of attending the school in the future. These plans are offered either by nine U.S. states or through specific higher education institutions.
However, they come with a few drawbacks. Many state-run prepaid tuition plans require that the account holder be a resident of the offering state. Furthermore, these plans typically lock in the tuition at a specific institution or group of schools, limiting the beneficiary’s flexibility when it comes time to choose a college.
If you’re looking for a more flexible option, a 529 College Savings Plan may be more suitable. These plans are state-administered and generally available to both residents and non-residents, except in seven states—Louisiana, Florida, New Jersey, South Carolina, South Dakota, and West Virginia—which restrict participation to residents only.
The benefits of 529 College Savings Plans are considerable. There is no age limit for beneficiaries, contribution limits are extremely high but capped, and there are no income limits for contributors. One of the most popular features is the inclusion of target-date funds, which gradually shift toward more conservative investments as the beneficiary nears college age.
That said, 529 plans have some unique rules. Contributions are considered gifts for tax purposes, so gift tax rules apply. The annual exclusion limit is $19,000, meaning contributions above that amount in a given year may require tax reporting. However, you can elect to make a lump-sum contribution equal to five years’ worth of gifts without triggering the gift tax.
In contrast to the ESA, investment choices in 529 plans are more limited—typically restricted to mutual funds—and you can only change your portfolio selection twice per calendar year. Still, for many families, the benefits outweigh these constraints.
Although 529 contributions are not tax-deductible at the federal level, the plan grows tax-deferred, and withdrawals are tax-free when used for qualified education expenses. However, the definition of “qualified” is more narrow than that of the ESA. While both ESA and 529 plans allow for K–12 and postsecondary education expenses, the 529 plan caps K–12 expenses at $10,000 per year. It also permits a lifetime maximum of $10,000 in student loan repayments from plan funds.
Because 529 plans are state-sponsored, some states offer additional tax benefits such as deductions or credits for contributions. These benefits vary, but the general rules described here are accepted nationwide.
As with ESAs, unused 529 funds can be reallocated to avoid penalties. You have three main options:
- A once-a-year, tax-free rollover to another 529 plan for the same beneficiary or for a qualified family member. 2.
- If you maintain the current plan, you may change the beneficiary to a qualified family member without performing a rollover. 3.
- Thanks to the Secure 2.0 Act of 2022, you may transfer up to $35,000 from a 529 to a Roth IRA, provided the account has been open for at least 15 years and the funds transferred (including gains) were contributed more than five years ago.
It’s important to note that any non-qualified distributions from a 529 plan will be subject to federal income tax and an additional 10% penalty on the withdrawn earnings.
Lastly, both ESA and 529 plans have a valuable impact on FAFSA (Free Application for Federal Student Aid) calculations. FAFSA assesses the financial resources of students and their families to determine eligibility for federal aid. One important factor is how savings accounts are counted: Parent assets are typically assessed at 5.64%, while student assets can be assessed at rates as high as 20%. Fortunately, both ESAs and 529 plans are treated as parental assets, resulting in a lower impact on aid eligibility compared to assets held in the student’s name.
Let’s consolidate the information we covered into a table that will be much easier to comprehend.
| Categories | Coverdell ESA | 529 Plan(s) |
| Beneficiary
limits |
Younger than 18 years old, or special needs | No limit |
| Contribution
limits |
$2,000 a year per beneficiary | Near uncapped ($235,000-$575,000) lifetime limits |
| Grantor income limits | $95,000 for individuals, $190,000 for joint | No limit |
| Contribution
type/tax benefits |
Post-tax dollars, non-deductible | Post-tax dollars, non-deductible |
| Qualified
education levels |
K-12 and postsecondary | K-12 and postsecondary |
| Qualified
expense list |
Wide range | Much stricter range |
| Investment
options |
Wide range, including ETFs, traditional assets, and alternative investments.
|
Limited options compared to ESA’s, primarily ETFs, Mutual funds, and age-based portfolios.
|
| Changing investment within portfolio | Unlimited | Twice in a twelve-month period |
| Distribution
age limit |
Must empty by 30 years old, unless special needs | No age limit |
| Qualified expense withdrawal | Tax-exempt on entire withdrawal, including capital gains | Tax-exempt on entire withdrawal, including capital gains |
| Non-qualified expense withdrawal penalty | Taxed to beneficiary as income tax, including 10% withdrawal fee | Taxed to beneficiary as income tax, including 10% withdrawal fee |
| Roll over
to likewise account |
Can rollover once every year, ensure beneficiary receives rollover is a qualified family member of current beneficiary.
|
Once a year, tax-free, rollover to same beneficiary of qualified family member of beneficiaries 529 |
| Roll over
to one another |
Can roll over funds from ESA to 529, one time, tax-free, to same beneficiary | Can not roll over funds from 529 into a Coverdell ESA |
| Other
rollover options |
None | 529 to Roth IRA option, 529 must be open for at least 15 years, maximum of $35,000 lifetime rollover, Can’t rollover contributions or CG from last five years |
| K-12
options |
Can use unlimited qualified withdrawals for K-12 | $10,000 a year maximum |
| Student
loan options |
Can not use for student loans | $10,000 lifetime maximum usage |
| FAFSA
asset assessment |
Parental asset assessment (5.64%) | Parental asset assessment (5.64%) |
INNOVA is a SEC registered investment adviser. Information presented is for educational purposes only intended for a broad audience. INNOVA is not giving tax, legal or accounting advice, consult a professional tax or legal representative if needed. The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Any opinions, projections, or forward-looking statements expressed herein are solely those of author, may differ from the views or opinions expressed by other areas of the firm, and are only for general informational purposes as of the date indicated. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.