529 College Savings Plan vs. Coverdell ESA

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As part of our preparation for parenthood, my wife and I have been examining college savings programs. The two most common college saving plans are the 529 College Savings Plan and the Coverdell Educational Savings Accounts (ESAs). 529 College Savings Plan vs. Coverdell ESA Similarities. These college savings plans both work similar to Roth IRAs…

As part of our preparation for parenthood, my wife and I have been examining college savings programs. The two most common college saving plans are the 529 College Savings Plan and the Coverdell Educational Savings Accounts (ESAs).

529 College Savings Plan vs. Coverdell ESA

Similarities. These college savings plans both work similar to Roth IRAs – contributions are non-deductible and grow tax free. Withdrawals are also tax free for qualified higher education expenses. 529 Plans and Coverdell ESAs are viewed the same for financial aid purposes. They are considered the assets of the custodian (the person who opened the account), and withdrawals by the beneficiary are not considered taxable income when used for college expenses. Both plans can be transferred to another beneficiary without penalties or fees.

Differences. The major differences between the 529 Plans and Coverdell ESAs are listed below.

Types of accounts:

Control of account:

  • 529 Plan: Account holder controls when withdrawals will be made and for what purpose, and can change beneficiaries at will. There are no restrictions regarding when funds must be used.
  • ESA: Account holder can change beneficiary at will. If money is not transferred to a new beneficiary or used for higher education costs, then the beneficiary receives the assets when they turn 30 and the account will be assessed taxes and penalties.

Age limit for contributions and withdrawals:

  • 529 Plan: None.
  • ESA: Must be under 18 to receive contributions, must use assets before age 30.

Contribution limits:

  • 529 Plan: Between $100,000 and $350,000 depending on state
  • ESA: $2,000 per year from all sources

Income limits for contributors:

  • 529 Plan: No income limit.
  • ESA: To qualify for the max $2,000 contribution, your AGI must be less than $95,000 for single filers and $190,000 for married couples. Contributions will drop to $500 per year in 2010 if Congress does not extend the current limits. More about ESA contribution limits.

State tax deductions or credits for contributions:

  • 529 Plan: Yes, depending on state plan and residency.
  • ESA: No.

Uses for plan assets:

  • 529 Plan: Higher education only.
  • ESA: Through 2010 assets can be used for K-12 and higher education.

Investment options:

  • 529 Plan: Stocks, bonds, mutual funds, CDs. Can only change investment allocation 2 times per year.
  • ESA: Stocks, bonds, mutual funds, CDs. No limit to changes in investment allocation.

529 College Savings Plan offers more flexibility than a Coverdell ESA

In my opinion, the 529 Plan is a more versatile plan, especially if you will have other people contributing money toward your child’s education – the $2,000 limit for ESA contributions is more difficult to track when there are multiple people contributing.

The Coverdell does have several advantages, including the ability to use the funds for K-12 (through 2010 unless extended), make unlimited changes to asset allocation, and ESAs may have better investment options, depending on the state in which you open your 529 College Savings Plan.

The good news is that you can have both plans for your children and you can roll a Coverdell ESA into a 529 College Savings Plan. These plans have a lot of small print and conditions, so I recommend reading the details for your state 529 plan or reading more about the Coverdell ESA before opening an accout and making contributions.

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About Ryan Guina

Ryan Guina is the founder and editor of Cash Money Life. He is a writer, small business owner, and entrepreneur. He served over 6 years on active duty in the USAF and is a current member of the IL Air National Guard.

Ryan started Cash Money Life in 2007 after separating from active duty military service and has been writing about financial, small business, and military benefits topics since then. He also writes about military money topics and military and veterans benefits at The Military Wallet.

Ryan uses Personal Capital to track and manage his finances. Personal Capital is a free software program that allows him to track his net worth, balance his investment portfolio, track his income and expenses, and much more. You can open a free account here.

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  1. Miranda says

    Great post. I like the idea of a 529, but at the same time, I need to find a state that has more flexible terms. Some of them are rather restrictive when it comes to out-of-state schools. And, of course, there are fees to consider…

  2. Miss M says

    Good info, we don’t have kids yet but I’m already thinking through the financial ramifications! I don’t like the restrictive nature of 529’s, I prefer the ESAs in that respect. I didn’t know you could have both types of accounts. Did you see the article the other day about prepaid tuition plans, many can no longer guarantee full tuition. So parents who paid into the plans expecting full coverage will probably have to fork over more cash, that makes me very wary of those types of plans.

    • Ryan says

      Miss M: I didn’t see the article about some plans not being able to honor prepaid tuition, but it doesn’t surprise me at all. My plan is to start saving now and hope we can make a substantial dent in the bill when it arrives. If we don’t have enough saved, we can figure that part out then.

  3. Adam @ Checkbook Diaries says

    I recently posted an article about a flaw that I see with educational savings plans. Getting out of debt is a very valuable experience that should be learned very early on. College can be a great example of incurring debt and working your way out of it. Although I plan to pay for my child’s education, I plan to REpay them after they have already incurred the debt and paid it off. I won’t be telling them about my plan until I give them the money, and that won’t be until they are well out of college and established. I hope that by incurring what I see as a good debt and having that financial burden as soon as they get out of college, they will be less likely to incur consumer debt early on. They’ll also have an opportunity to learn better real life budgeting while account for debt repayment.

    From what I have read, it doesn’t look like assets from 529 plans can be used to pay for student loans or student loan interest, which is why I’ll be saving through an alternate investment vehicle.

    • ~ Brent ~ says

      That has got to be one of the dumbest things I’ve ever heard. I’m going to hid a wad of cash from my kid, have them incur debt for 4-6 years – all the time collecting interest. Then come in and “save the day” and repay their school loans after the fact. All for the hope that it’ll curb their appetite for consumer debt. You have no insight into the mind of a 24yr old apparently. He or she will find a way to justify a $30,000 new car, $4,000 bedroom set, a plasma TV or whatever else they want because they’ll be able to afford the monthly payment and they “deserve it” after their hard life as a college kid.

      You need to work with your kids when their young to instill that consumer debt can be dangerous. Set an example yourself by following the principles you want to instill in them. Find ways to reward them when they demonstrate the behaviors you want to foster – If they save $4,000 for a their first car, match them dollar for dollar (only if they pay for the car with cash). Give them a large allowance, but make them buy their own cloths, cell phone plan, gifts for their friends, ect – work with them to show them how to budget. This builds principles that hopefully will pull through the college years.

      I’m sorry, I can’t find any logic in this strategy.

      Good luck with that.

  4. iu mike says

    Any ideas what to do with 529 and ESA funds that will not be used for traditional academic expenses. My youngest daughter has elected to forego traditional college education and become a cosmetologist. This institute she is going to is not esa or 529 eligible and I have no one to roll this over to. I have heard that the principal can be taken out w/out tax or penalty; if the funds are lower than initial contributions can they be cashed out? no one seems to know

    • Steve Williams says

      Hi Mike:

      You can cash them out. You will have to pay taxes on any gains as well as a 10% penalty on the total balance.

      That’s one good reason to keep a portion of you investments for a child’s education in a standard brokerage account. Sure you would taxes every year, but you would have more investment options and total flexibility to do with it as you wish.

  5. Ryan says

    iu mike: I don’t have a definitive answer for you. I recommend contacting a CPA or other qualified professional. They should be able to give you an answer that will maximize your money and hopefully avoid the most taxes/penalties. Best of luck.

  6. Steve says

    What’s often not dicussed is that most 529 plans consists of repackaged poor performing mutal funds that brokerage houses have limited inflows.

    The Coverdell gives you total control of your investments. Do some research and buy some good stocks or mutuals funds. Your return on invesments should handly beat most 529 plans.

    • Ryan says

      Steve, I have my 529 plan in OH which features many low cost index funds run by Vangaurd, which are among the cheapest options available, and which many people would no doubt consider if they were using a Coverdell plan. Most states allow you to use their fund even if you are not a resident, so it is worth shopping around. Coverdell plans are also more limited in terms of how much you can contribute and plan portability. So you should consider your needs for both the fund(s) you choose and which college planning vehicle you choose. For some people the 529 is a better fit.

      • Steve Williams says

        Hi Ryan:

        Most 529 plans are a repackage of mutual funds that fund companies can’t sell. Considering your in low costs index funds that’s a good first step. But keep in mind you have limited flexibility of how often you can change your investments – so your 529 would of took a bath last year. With Coverdell you could of moved to a safer alternative. A savvy investor will consistently beat 529 plans returns. Considering Index funds for a Coverdell would defeat the purpose of the unlimited investment options.

        The biggest drawback of a Coverdell is the contribution limit of $2000/year. If want to invest more than that amount I would recommend to max out your Coverdell first than go a 529.

        If wish go to http://www.eistrading.com and click on subscription information and write “complimentary” copy on the referral line and send in the subscription form. They will send you a complimentary copy of “The Educational Investor” which deals with many types of investments. Their Coverdell is up 24% for the year.



        • Ryan says

          Yes, it is very possible to beat index funds, but the vast majority of people who sign up for educational accounts don’t have the ability or desire to manage a fund well enough to beat index funds.

          For someone who is willing to put in the time and effort to maximize returns, then contributing up to the $2,000 limit for a Coverdell, then contributing to a 529 plan may be the best option.

  7. Chris Hendrickson says

    Great article. Simple to understand and breaks down the complexities of each into pros and cons that a non-saavy investor can grasp. As a small business owner of aweb design and promotion firm I am always looking for ways help my clients grow and sucres in their business, but as a parent my job is to help ensure the success of my children. Giving them a head start on a college education is a key to success these days. I too have done a decent amount of research, and I find that your points are right on. I have also heard of people stacking an ESA on top of a 529 plan. Since you can change the invesents in an ESA anytime without limit, it provides a level of flexibility in a changing financial landscape. If your state offers a good 529 plan though with a track record of success this would be a very good option. Some states have great incentives to go that direction.

  8. LeeAnne says

    I have a question about withdrawing from a 529. After much searching on this issue, I have come up with different answers. If you withdraw from a 529 in the same year you received a financial aid student loan, can you use the withdraw to pay back the loan. I have read that as long as you do it in the same year, yes you can. Is this true? For example, my daughters tuition was approx. 11,000 this year she received 8,000 in loans, the rest in scholarships. Can I use the 8000 she has in a 529 to pull out and pay back the loans this year? This is her last year of college.

    • Ryan Guina says

      LeeAnne, I don’t have a confirmed answer for you. I recommend you contact a tax professional to make sure you get the most up to date information.

  9. Daniel says

    Hello, can I contribute to the maximum of $2,000 to the ESA account of my son if I am a divorced parent? I do not know if my ex-spouse has opened any ESA account or how much she might have put in it. Apparently I do not want to do any “coordination” with my ex- on this contribution. Thank you.

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