Financing Education: Coverdell ESA vs. 529 Plans

Personal Finance

Jan 25

Saving for the future education of your child(ren) is often a daunting prospect. After all, the average cost of attending an in-state public college/university starts at $10,940 a year and exceeds $39,000 annually should your child elect to attend a private nonprofit school (per recently published College Board data).

The good news, however, is that you do have options to successfully finance your child’s future education. Two of the most common vehicles are education savings accounts—also known as Coverdell accounts—and 529 college savings plans.

An overview of 529 college savings accounts

A 529 plan is an investment account that offers tax advantages when the saved funds are used for qualified educational expenses. State governments sponsor these funds, with each state boasting different options, rules, and benefits.

The main selling points of a 529 savings plan are that contributions you make can grow tax-deferred and withdrawals—when used for qualified education expenses such as tuition, books, and other related costs—are also tax-free at the federal level. Many states also offer additional tax benefits such as state income tax deductions and credits for 529 plan contributions.

You can choose from many different types of 529 plans, with most categorized as either a “prepaid tuition” or “college savings” plan.

College/education savings plans
Education savings plans function similarly to a Roth IRA in that they feature after-tax contributions and investments (often mutual funds or the like) grow tax-deferred.

College savings plan funds are flexible, as you can generally use them for tuition at any college or university—including eligible international schools. They can also cover college room and board expenses, offer expanded coverage for qualified K-12 school tuition (up to $10,000 per year), and be used to pay off student loans (with a $10,000 lifetime limit). Furthermore, various options are available should the account beneficiary no longer need the money due to a scholarship or college plan change—this includes shifting to a new beneficiary or rolling over a portion of unused funds to a Roth IRA account.

Nevertheless, a college savings plan doesn't come with any guarantees; and while you can choose your investments, they may not always perform exactly how you need them to. Consequently, it is in fact possible to lose money and fall short of your savings goals.

Prepaid tuition plans
Just as the name suggests, a prepaid tuition plan is a contract that allows you to pay for your child's future college tuition in advance. You can do so via a lump sum or regular installments, using after-tax money to purchase "units" or "credits" with either option.

The price of these credits is determined prior to purchase and varies based on the current age of the beneficiary, estimated cost of tuition, and projected rate of return. With prepaid plans, you don't personally choose any investment options; instead, plan administrators (state governments) pool the money and make investment decisions on your behalf.

One appealing feature of prepaid accounts is that they protect you from tuition inflation, as most states guarantee funds will cover future tuition rates. This is especially important when you consider a recent report from the Education Data Initiative (a research organization), which claims college tuition inflation averaged 12% annually from 2010 to 2022.

Unlike many alternative investment options, prepaid tuition plans offer high contribution limits (set by each state): allowing you to pay enough to purchase all necessary credits. You also won’t lose money if your child decides to attend an out-of-state school, as plan benefits can be applied to any eligible institution. Moreover, you can request a refund on your prepaid account should you no longer need the money.

Although most prepaid plans are only available to residents of that same state (and generally feature limited enrollment periods), a “private college 529 plan” (also referred to as a “private prepaid tuition plan”) is sponsored by hundreds of nationwide private colleges and universities and doesn’t include state residency requirements.

With respect to how prepaid tuition plans work, the buyer purchases tuition “certificates” to redeem at any participating college. Contributions grow tax-deferred, and withdrawals are tax-free when used for qualified education expenses. As with state-administered plans, flexibility does exist should you ultimately not require the funds; this includes naming a new beneficiary or requesting a refund.

Prepaid tuition plans are guaranteed by participating schools despite any tuition increases over time but do not offer year-round open enrollment like their private college 529 plan counterparts.

529A savings plans

During your research, you may stumble across 529A savings plans: also known as “ABLE” (“Achieving a Better Life Experience”) plans. These accounts are state-run and provide individuals with disabilities and their families with a tax-advantaged way to cover qualifying disability-related expenses. Read our article for more information about financial planning for special needs children.

An overview of Coverdell education savings accounts

A Coverdell education savings account (ESA) is a trust or custodial account set up solely to pay qualified education expenses for the designated account beneficiary. You can open these at almost any brokerage firm, bank, or credit union.

As with 529 plans, Coverdell accounts are funded with after-tax dollars and the money in your account can grow tax-free. This option is more flexible, however, as you can apply these funds toward expenses beyond tuition and fees. Qualified elementary and secondary education expenses include books, supplies, Internet access, computer equipment and technology, academic tutoring, and special needs services.

Coverdell ESA limitations

Despite their appeal, not everyone is eligible to open these types of accounts. For example, if your 2024 modified adjusted gross income (MAGI) exceeds $110,000 (for single filers) or $220,000 (for married couples filing a joint return), you won’t qualify. Note that these income thresholds aren’t imposed on trusts or corporations that make contributions to the account.

Keep in mind the maximum annual contribution limit for these accounts is only $2,000 per child (as of 2024) and that the designated beneficiary must be under 18—unless he or she is a special needs child—when the account is established. Contributions are prohibited after the beneficiary turns 18, and a failure to adhere to this rule could result in a 6-percent excise tax.

Financial aid impact

Fortunately, both 529 and Coverdell plans have minimal bearing on financial aid. Furthermore, due to recent FAFSA (Free Application for Student Aid) changes, students will no longer be required to report any financial support they receive from friends or family per the new FAFSA rules, including distributions from grandparent-owned 529 college savings plans.

Potential tax implications

Regardless of the type of savings vehicle, tax-free earnings and withdrawals apply only when funds are used for qualified expenses. Should you put the money towards non-qualified expenses, the earnings portion of that amount is subject to ordinary income tax and a 10% penalty—although some exceptions apply to both 529 and Coverdell accounts. Some states may also impose additional penalties on 529 plans.

With a Coverdell account, you’re required to distribute the account by the time your child turns 30 (or, alternatively, roll it over to another child). Any money left in the account when the student turns 30 must be withdrawn within 30 days; a failure to do so means the earnings portion is subject to income tax and a 10-percent penalty tax.

While most people will never be required to pay a gift tax, know that the IRS does impose a tax on large gifts: including 529 plan contributions. More specifically, if your gifts total more than $18,000 per recipient in 2024, you’ll need to file a gift tax return. Excess contributions above this threshold will also count against your lifetime exemption of $13.610 million (as of 2024), and you’ll only need to pay taxes after exceeding this amount.

Other Coverdell and 529 account considerations

Anyone (family, friends, etc.) can fund either type of account, provided they meet qualification requirements. You can even open a 529 account and designate yourself as the beneficiary.

Over 30 states offer a state income tax deduction or credit for 529 plan contributions; in most cases, the taxpayer must contribute to his or her home state’s 529 plan to qualify for a state income tax benefit.

Coverdell vs 529 plans: choosing between both options

A 529 plan is typically best for most families, especially considering the cost of college and that no annual contribution limits exist (note that aggregate limits do vary by state). However, for some—especially those who don’t want to (or can’t) contribute more than $2,000 annually or desire more flexibility in paying for elementary/secondary school expenses—a Coverdell ESA may fit the bill.

The bottom line: 529s vs. Coverdells

A 529 plan is a great higher education savings tool given its lofty contribution limits. On the other hand, a Coverdell ESA is great for those with K-12 expenses beyond tuition costs or those seeking greater diversity for college savings investments. Don’t know which option is best for you? Consult a financial advisor who can help you assemble a comprehensive plan for your own unique situation.

Still have questions about saving for higher education expenses? Schedule a FREE Discovery call with one of our CFP® professionals.

FAQs

Yes, your child can serve as the beneficiary for both and contribute to both accounts in the same year.
Generally speaking, it’s best to withdraw from a Coverdell first as this requires you to withdraw all funds before the beneficiary turns 30 (whereas 529 funds can be used later on to help pay student loans or be partially rolled into a Roth IRA).
Yes, provided the 529 plan has the same beneficiary as the Coverdell plan (only one rollover is allowed over a 12-month period). You cannot, however, roll over funds from a 529 plan into a Coverdell account. Most people consider a rollover when the beneficiary approaches his or her 30th birthday, given the corresponding limit.
In addition to offering more flexibility with respect to how you use the funds, Coverdell accounts often feature lower fees and very few restrictions on investments choices (whereas a 529 typically limits you to mutual funds and other investments offered within the plan).
While 529 plan holders can withdraw a lifetime maximum of up to $10,000 to pay down student loans for the beneficiary, you cannot use a Coverdell account to repay student loans.
Yes. You can also avoid any taxes or penalties if you deposit the funds within 60 days for the same beneficiary or another qualifying member of the family.