Millions of parents and grandparents have poured billions into 529 accounts to fund their beneficiaries' schooling since the tax-advantaged savings plans were created by Congress in 1996. All 50 states and the District of Columbia offer some form of the plan, but it's not the only such program out there.
A year after a bipartisan effort by Sen. Bob Graham (D-Fla.) and Sen. Mitch McConnell (R-Ky.) led to the creation of Section 529 of the Internal Revenue Code, Sen. Paul Coverdell (R-Ga.) championed the creation of what are now known as Coverdell Education Savings Accounts (ESA) as another option for folks seeking to finance their kids' higher education down the road.
About $400 billion is now invested in 529 plans nationwide, vastly more than in ESAs, but both plans operate much like Roth IRAs. The contributions are neither pre-tax nor tax-deductible, but no tax is due on contributions or investment gains when the time comes to help fund an education.
So, which is better? Some significant differences between the two could determine that answer for you, but one of the major differentiators has recently gone away.
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Contribution limits are a major difference
The biggest difference is the amount you can contribute each year. Coverdell ESAs are capped at $2,000 in annual contributions. There's also an income limit to be eligible to contribute each year: $110,000 a year for single adults and $220,000 a year for a married couple.
There are no annual limits for 529 contributions (stay alert to gift tax ramifications), nor are there any prohibitions for those with incomes above a certain limit. But each state has its own limit for the total contributions to the account. For 2023, they range from $235,000 in Mississippi to $569,123 in New Hampshire. The limit is $550,000 in five states: Connecticut, Texas, Vermont, Virginia, and West Virginia.
The assets can grow beyond those limits, of course. Hopefully they will, since the money is invested and that's the point of investing in the first place. But be aware that each state has its own mix of other 529 program features, including additional tax credits and allowable education expenses. A handful of states also require the account holder to live in the state that sponsors that particular plan.
Flexibility and other considerations
Until a few years ago, Coverdell plans had one big advantage over 529 plans: Coverdells could be used for K-12 education expenses as well as college. However, that distinction no longer applies. There are some minor differences around qualified expenses, but in general, 529s and ESAs can be used for K-12 as well as college education, apprenticeships, and other training.
But 529s, it should be noted, can be used to pay up to $10,000 in student loans. Coverdell ESA funds cannot be used for that purpose.
Conversely, Coverdells are more flexible at the investing level. Coverdell ESAs are self-directed accounts, allowing you to invest in a wide range of different investments, from mutual funds and ETFs to individual stocks. 529 accounts are externally managed mutual fund plans with limited investment menus.
Another difference: Coverdell ESAs must be disbursed to the beneficiary by age 30 to avoid penalties and taxes. There's no such restriction on 529s. Of course, there's always the chance of having unused funds when the gifting comes to an end, but beginning in 2024 there's a promising solution: Investing the money back into a Roth.
So, which is best?
Well, you can do both. Your child or grandchild can be the beneficiary of a 529 account and a Coverdell ESA at the same time. That said, the variety of accounts and investment options can be tailored to fit your situation.
For higher-income grandparents and families saving for multiple kids' educations, the high limits and tax benefits make 529 plans quite appealing. For moderate savers, Coverdells may work better.
The simple truth of the matter is that $2,000 a year even from kindergarten on likely won't pay for much college when the time comes. But it's the thought that counts, and it's part of the whole funding package when, again, that time comes.
You'll also need to consider your own state and federal tax situation, investment options, and financial needs. A good financial advisor might be helpful here. But even if you go it alone, the key is starting to save early, so your child has resources down the road.
