529 vs ESA: Key Differences for College Savings

BY BRANDON VAGNER, CPA, Ph.D., & WALLET WIT FOUNDER

529-Plan-vs-ESA-College-SavingsWhen my wife and I had our first baby, we had to decide between utilizing either a 529 College Savings Plan or an Education Savings Account (ESA). It’s a decision all parents have to make, but it’s not an easy one without having all the information on 529 vs ESA. You’re in the right place because I’ll lay out, nice and easy for you, everything to know about these two different college savings options.

It could be the Certified Public Accountant (CPA) or Accounting Professor in me, but I get REALLY into saving for college because I know how powerful an education can be for a person’s career and life. It is such a great gift to give to someone.

Buckle up and let’s get into it. Remember though that the single most important thing you can do is act on your instinct to start saving now. Don’t be like the 35% of American parents who are not planning or saving for their child’s future college needs. Force yourself to sign up today for a college savings account. The longer you wait, the more likely you are to never start saving. That’s not an option.

What is a 529 Plan?

To explain what a 529 plan is, I first need to highlight that not all “529 plans” are the same. You will hear many people use the term 529 plan, but it’s extremely important to know there are actually two very different types of 529 plans. There is a 529 prepaid tuition plan and a 529 college savings plan. I will explain what each of these are individually because they are MASSIVELY different.

529 Prepaid Tuition Plan

Through a 529 prepaid tuition plan, you are buying tuition credits for future use at today’s price. Specifically, tuition credits for very specific state colleges or systems. This can get complicated if your child decides to go to a different university. You may not be guaranteed to get back the full value of the credits you purchased. You also don’t get the benefit of compounding interest through a prepaid tuition plan.

Bottom Line – My opinion is that the 529 prepaid tuition plan is NOT the optimal option between these two 529 plans, BUT the 529 college savings plan discussed below is.

529 College Savings Plan

A 529 college savings plan is an account with massive tax advantages similar in nature to a Roth IRA. Assuming you spend your 529 college savings plan funds on qualified education expenses, you won’t pay taxes on your 529 college savings plan investment earnings.

The 529 college savings plan is what I chose for my child because I’m guaranteed to realize full benefit of the plan balance wherever my son goes to college and I have control over the investment allocations of my contributions. Basically, the 529 college savings plan enables you to contribute to funds offered by the plan. Similar to a Roth IRA, you should benefit from tax free compounding interest over time. Assuming you follow the distribution rules discussed below.

You may be saying to yourself that you don’t want to mess with allocating your contributions to investments, but it can be very EASY. It does not have to be complicated. Warren Buffet, along with many other investment gurus, recommend simply investing in a S&P 500 index fund with low fees. In doing so, you’re basically investing in the top 500 companies without having to buy all their stocks individually. So, you’re extremely diversified and you are invested in the best large companies out there. Investing in a S&P 500 index fund is a great way to invest without having to think about it too much, and it has a very strong proven track record over decades. Most of the large investment fund managers can’t even beat the S&P 500 performance.

What is a Coverdell Education Savings Account (ESA)?

The first thing you must know is that the Coverdell Education Savings Account (ESA), which is a tax advantaged education savings account, is very similar to the 529 college savings plan, but there are MAJOR differences. The biggest similarity is that there are no taxes due on earnings distributed from either of the two so long as the total distribution is less than or equal to adjusted qualified education expenses, which are highlighted below. Meaning, you contribute and the money grows tax free so long as you end up spending it on qualified education expenses.

The problem with ESAs is that the annual contribution limit of $2,000 is very low and the funds must be used before the student reaches age 30, or there will be taxes and penalties. Also, not everyone can invest in an ESA as a result of the income limits. See below for the adjusted gross income limits.

Let’s now take a much more in-depth look at the differences between the 529 college savings plan and ESA.

Primary Differences Between the 529 College Savings Plan and Education Savings Account (529 vs ESA)

NOTE: For the remainder of this article, “529 College Savings Plan” will simply be referred to as a “529 plan.”

Let’s first make sure you don’t make too much money for either the 529 plan or ESA.

529 and ESA Income Limits:

529 Plan Income Limits:

There are NO income limits for the 529 plan! That goes for anybody no matter their federal filing status.

Coverdell ESA Income Limits:

Married couples filing jointly who make under $190,000 can contribute the maximum amount allowed to an ESA.  The maximum allowed is discussed under contribution limits below. If you make between $190, 000 and $220,000, then you can contribute an amount based on the phase out rules. If you make above $220,000, then you are above the thresholds for ESA contribution. For you single filers, your income limit is $110,000.

529 and ESA Contribution Limits:

The 529 plan wins when it comes to contribution limits. The first thing you have to know is that every state sets their own max contribution limit. I’m not talking annual limits here. I’m talking about the overall limit to the entire account. The lowest state limit is $235,000, but there are some states that allow as much as $529,000. The next question becomes, how much can you invest annually in a 529 plan? Well, we have to turn to gift tax limitations to answer that.

Based on the present laws, you can “gift” up to $15,000 per year to each beneficiary. However, 529 plans have a unique rule that allow a person the ability to contribute up to 5 years worth of “gifts” in one lump sum. Since current gift tax laws allow $15,000 annually, that would mean anyone could gift into a 529 plan $75,000 ($15,000 x 5 years) in one lump sum. The key though is that person cannot gift again to that beneficiary for 5 years without tax consequences.

The ESA has an annual contribution limit of $2,000 per child. That’s the contribution restriction you would have if you went with a Coverdell ESA. You can see how the 529 plan allows for significantly greater contributions than the Coverdell ESA.

529 and ESA Age Rules:

Unpredictability is something all parents can relate to when it comes to children. The fact is that you can’t know exactly how adulthood is going to play out for your child or any beneficiary. It’s very possible they may not pursue a college education until later in life. The beauty about a 529 plan is that there are no age restrictions. If your child wants to wait until they’re 35 to pursue an education, that’s no problem with the 529 plan. However, if you choose an ESA, then you must utilize the funds by the time your child reaches the age of 30. So, you have a hard deadline with an ESA, but you don’t with a 529 plan.

What Type of Educational Expenses Qualify for both 529 and ESA?

A flexible aspect of an ESA is that in addition to college expenses, some elementary and secondary (i.e. high school) education expenses are allowed to be distributed tax-free. Examples of these qualifying expenses are tuition, fees, books, and supplies. This applies to both public and private school costs. It’s important to know though that the earnings portion of non-qualified distributions are taxed and you will be subject to an additional 10% penalty.

The 529 plan had historically been designed for college expenses only, but the IRS has made recent changes to the 529 plan that expanded qualifying expenses beyond just college. College tuition, room and board, and supplies are all considered qualifying educational expenses. Supplies being items such as your class books, iPad, computer, etc. Additionally, you can now use up to $10,000 annually for each student to pay for their K-12 private, public, or religious school tuition. Notice though that if you use your 529 plan funds for private K-12, tuition is all that is considered a qualified expense. That’s very different than the more broad qualified expenses discussed above for ESAs. All that said, be very careful if you use 529 plan funds to pay for K-12 tuition because not all states are on the same page as the new federal regulation. Meaning, you may have state tax implications.

Tax Considerations For Qualified Distributions (529 vs ESA)

Distributions of both the 529 and ESA are tax free if you utilize the money for qualified education expenses.

Tax Considerations For Non-Qualified Distributions (529 vs ESA)

You have to first know that when you put money into a 529 plan or an ESA, you are doing so after taxes. Said another way, your contributions are not done pre-tax. Having said that, you can always distribute your original contributions tax free, and they will not be subject to any penalty.

For both a 529 plan and an ESA, if you distribute any earnings (i.e. investment gains) for purposes of non-qualified expenses, then the earnings portion of your distribution will be subject to tax AND a 10% penalty.

Is the 529 Plan OR Coverdell ESA a Smart Choice?

In short, my opinion is that the 529 plan is the smart choice, but specifically the 529 college savings plan. Not the 529 prepaid tuition plan.

Can You Lose Money in a 529 Plan?

There are two BIG aspects to whether or not you can lose money in a 529 plan.

First, most people ask this question in terms of what happens if the designated beneficiary doesn’t go to college or if their college is cheaper than expected and they have left over money in the 529 plan. Do you lose that money or not?

Secondly, many people also wonder if their contributions are “at risk.” Meaning, is it possible you could lose the money you put into a 529 plan before the beneficiary even needs to use the money.

These are both very good questions. Let’s start with the first. If for some reason you have money left in a 529 plan, you can transfer the money to a qualifying family member. That said, I realize you might not want to use the money on anyone else. What then? If that is the case, you don’t want to have much money left over in a 529 plan, because the left over portion of the money that is a “gain” on your contribution would be subject to tax and you would be assessed a 10% federal penalty for non-qualified distributions on that earnings portion.  Remember though that your original contributions were made after paying tax. So, that original contribution money can be distributed out of the 529 plan without federal tax or penalty.

All that said, there are a few unique scenarios when you don’t have to pay the 10% penalty for non-qualified distributions.

529 Plan Non-Qualified Distribution Penalty Exceptions

  1. Beneficiary receives a scholarship
  2. Beneficiary dies
  3. Beneficiary enrolls in a U.S. service academy

These exceptions exempt you from the 10% penalty, but the “gain” portion of the 529 plan non-qualified distributions would still be subject to taxes.

Now let’s switch gears back to that question of can you lose the money you put into a 529 plan before your beneficiary even needs to use the money? Basically, is that money at risk? Yes, you can lose your contributions.

Technically, you can put money into a 529 college savings plan and not allocate it out to an investment. You could technically just leave it in a money market account inside of the 529 plan. However, you wouldn’t be taking advantage of one of the most powerful financial benefits known to man, which is compounding interest. To get the benefit of compounding interest, you must allocate that money to an investment such as the S&P 500 index. If you do that though, your money would be “at risk” to the market. If the economy goes to crap, your 529 plan balance would go down. For example, I contributed $3,000 to my sons 529 plan immediately after he was born. Very shortly after that initial investment, his 529 plan balance was showing a pretty massive loss due to the financial effects of the COVID-19 pandemic. At one point, my original $3,000 investment fell to something like $2,300, BUT I didn’t panic. I just left the money in there knowing the market would turn back around. Ultimately, I have 18 years to recover from a market dip. That said, you will want to seriously think about your allocation the closer your child gets to utilizing the 529 plan funds for qualified expenses.

How Much Should You Put In a 529 Plan?

It depends! I know that’s not what anyone wants to hear, but it’s so true. I will walk you through my thought process on what I think tuition might cost in the future and what that means for my personal annual contributions to my son’s 529 plan.

Keep in mind that you can use your 529 college savings plan money to pay for both tuition and room and board. Individually and in combination, these are expensive today, but could be astronomical in the future. Who knows. I just know I don’t want to be scrambling down the road to pay for college. I want security in knowing my children’s education is 100% going to be covered by my 529 plan(s).

I’m assuming I will need $120,000 per child for 4 years of tuition and room and board. This is based on my best guess at where they might want to attend and a number of other factors. I realize some might say that’s way too low and others might say that’s way too high. You can adjust that based on your individual situation, but I will guide you through breaking down my annual contributions based on trying to get to an amount that is close to $120,000 per child.

You first have to understand what funds you plan on investing the money into. I personally will be investing in the S&P 500 index and other well performing mutual funds. Based on historical performance, I’m assuming my investments will realize an annual return of 7%. Keep in mind that is not guaranteed and some people have recently questioned whether the S&P 500 index will average 7% going forward.

RELATED: Best Place to Buy a Mutual Fund

Based on the estimate of a 7% annual return, I need to invest $250 per month into my sons 529 college savings plan to have any chance at reaching the $120,000. That comes out to a total annual contribution of $3,000, but remember that I started investing in his 529 college savings plan as soon as he was born. Had I decided to start later in his life when he was 5 or even 10 years old, that contribution amount would need to be much higher. Again, that doesn’t guarantee me to reach the $120,000 goal, but it should get me close. It all depends on how the economy performs. All I can do is remain consistent with my savings.

Best Places to Open a 529 Plan

You might now be asking yourself where you can invest in a 529 college savings plan. Well, I personally go through Vanguard directly because doing so gives me access to their S&P 500 index fund that has extremely low fees. You just have to make sure you specifically setup a 529 plan when you register. If you’re concerned at all about difficulty, don’t be. It’s extremely easy to setup and put on autopilot going forward. Their customer service is fantastic.

That said, there are many other places you could get into a 529 college savings plan.

Can Grandparents Setup a 529 Plan?

In short, yes! Grandparents can setup a 529 plan. It’s a wonderful way for them to give to their grandchildren.

Final Thoughts

As you can see, I decided to utilize a 529 college savings plan. I personally think the 529 college savings plan is a much better option than either a 529 prepaid tuition plan or an ESA. All of the reasons why are outlined above. Regardless of whether you follow my lead, just make sure you get started today. It’s incredibly easy to wake up 5 years down the road and not have anything saved. Good luck with your college savings! You’re doing a wonderful thing!