When it comes to saving for college, Americans have many possible choices. You can invest money in a brokerage account, save money in a checking, savings, or CD account, or you could even plan to use some of your retirement savings. However, there are two main savings vehicles specifically intended for college savings: the 529 savings plan and the Coverdell Education Savings Account, or Coverdell ESA.
Since these have some excellent tax benefits when funds are used for educational expenses, they are often the smartest way to save for college. However, many Americans have no idea how they work, or how to go about setting one up. With that in mind, here's a quick discussion of both account types and the pros and cons of each.
529 savings plans: High limits and potential tax benefits
529 plans technically come in two varieties: prepaid tuition plans and savings plans. However, prepaid tuition plans are becoming less and less popular and are only offered by a few states. So, we'll focus on 529 savings plans here.
529 savings plans are state-run. For example, South Carolina (where I live) has its own 529 savings plan, as do most other states. As far as investments go, 529 plans generally offer a variety of investment fund options, similar to a 401(k). There are usually some static investment options (meaning the investment focus stays the same), as well as some that adjust their asset allocations over time.
Both 529 savings plans and Coverdell ESAs are after-tax accounts, like Roth IRAs. This essentially means you don't get a current-year federal tax deduction for your contributions, but any qualifying withdrawals will be 100% tax free, and your investments will grow and compound tax-free while in the account.
Having said that, because of the state-operated nature of 529 savings plans, many states do offer a current-year state tax deduction for contributions. For example, South Carolina allows residents to deduct contributions to the state's plan, while some, like Arizona for example, allow residents a deduction for contributions to any state's 529.
On that note, it's important to mention that you don't necessarily have to contribute to your home state's 529 plan. So, if you're not particularly fond of the plan offered by your state, feel free to shop around.
A big advantage of 529 savings plans is that most have extremely high contribution limits. For example, the South Carolina Future Scholar 529 Savings Plan has a $426,000 contribution limit -- designed to be enough to cover a four-year college education at any school you can think of.
Coverdell ESA: Investment flexibility
A Coverdell Education Savings Account, or Coverdell ESA, is the other main option designed to help Americans save for college.
Unlike 529 savings plans, Coverdell ESAs are not state-run. You can open a Coverdell ESA through a broker of your choice.
The upside to this is that while a 529 savings plan is structured like a 401(k) when it comes to investment choices, a Coverdell ESA allows you to invest in virtually any stock, bond, or mutual fund you want. If you want to invest some of your kid's college fund in Disney stock, for example, a Coverdell ESA allows you to do it.
On the downside, this means Coverdell ESAs don't qualify for state tax benefits like many 529 savings plans do. To be clear, they get the same tax-advantaged treatment as 529s on the federal level, but your state isn't going to let you write off Coverdell contributions. If you live in a state that offers deductions for 529 contributions, this can be a big difference.
Another big downside of using a Coverdell ESA is the contribution limit. Coverdell contributions are limited to $2,000 per year. And this isn't a per-account limit, it's per-beneficiary. In other words, even if you, your parents, and an aunt or uncle all open Coverdell ESAs for your child, the combined annual contributions to all accounts can't exceed $2,000. If your goal is to pay for four years of college in full, a Coverdell is unlikely to get you there all by itself.
Tax reform took away a key advantage of the Coverdell ESA
One of the biggest advantages of using a Coverdell ESA to save for education is that you aren't limited to just college. Coverdell funds can be used to pay for qualified educational expenses at any level -- in other words, if you sent your child to a private high school, you could use money from a Coverdell to help pay for it.
Well, the Tax Cuts and Jobs Act has leveled the playing field. According to the bill, and to recently released guidance from the IRS, 529 plan distributions can now be used to pay as much as $10,000 in elementary or secondary school tuition per year, per beneficiary.
In a nutshell, the two key advantages of a Coverdell ESA have historically been the investment flexibility and the ability to use funds at other educational levels beside college. Now that 529 plans have higher contribution limits, potential state tax benefits, and more flexible uses of funds, it's tougher to make the case in favor of a Coverdell.
Why I chose a 529 for my kids (and you probably should, too)
I'm generally a fan of 529 savings plans over Coverdell ESAs, and in full disclosure, I use 529s to save for my children's educations. The first reason I do so is because I want to be able to set aside more than $2,000 per year -- especially while they are young and time is on their side. It has been estimated that public college could cost more than $50,000 per year by the time my infant son gets there. Even if my investments perform phenomenally well, I'm unlikely to accumulate nearly enough in a Coverdell alone.
In addition, I live in a state (South Carolina) that gives a state income tax deduction for 529 savings plan contributions, and this has saved my wife and I hundreds of dollars since we started setting money aside.
It's important to note that you can use both a 529 savings plan and a Coverdell ESA if you want. If you're set on putting some of your kid's college savings in, say, Apple stock, a Coverdell can allow you to do it, but I don't find it necessary in this case. Don't get me wrong -- given the choice, I love investment flexibility. For example, I've rolled over 401(k) accounts from previous employers into IRAs just so I could buy some individual stocks with the money. However, in a Coverdell, my investments would have to significantly outperform the market to justify giving up the state tax advantages.
Simply put, a 529 savings plan makes a lot more sense in my situation, as well as for most other American college-savers.
Matthew Frankel owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Walt Disney. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.