College Savings Plans: Differences Between 529 Plans and Educational Savings Accounts Explained
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As the cost of an education continues to rise, it’s more important than ever for parents take the initiative early and start to save for college as soon as possible. If you’re a parent and you’re making plans for your children’s future, you’ve probably encountered an overwhelming amount of information about different ways to save for college.
In particular, you’ve probably seen a lot of words or terms that industry experts use casually, but that just sound like gibberish to the average working parent. Terms like 529 Savings Account or Coverdell Education Savings Accounts (ESAs) raise a lot of questions. What’s the difference between a 529 savings plan and an ESA? What is the best college savings plan for my family?
What Is a 529 Plan?
529 savings plans are a form of tax-advantaged college savings account. What this means is that any withdrawals that you make to pay for qualifying education expenses from your 529 account are completely tax-free. Compare this with a personal investing account, where you could have to pay anywhere between 10 and 28 percent in capital gains taxes when you want to make a withdrawal, even if you use that money to pay for college.
If you start saving with a 529 plan, here’s how it will work. First, you will deposit money into the account. Right now you can deposit a maximum of $14,000 per year for each beneficiary on the account. The beneficiary is each future student whose educational expenses the 529 will help to pay. Once your money is in the account, the agency in charge of carrying out your 529 plan will invest it into a variety of money market and mutual funds. These are generally safe investments that are likely to grow at a steady and predictable rate over time.
When your child is ready to head off to college, you’ll be able to dip into your 529 savings account tax-free to pay for qualified expenses related to their education. These expenses include tuition, fees, books, and room and board at any institution that participates in the U.S. Department of Education’s student aid program.
What is the Difference Between a 529 Savings Account and Prepaid Tuition?
Not all 529 plans work this way. Some plans will have you purchase credits in your state. These credits will be based around the current cost of college in your area, but can be redeemed at state colleges in the future to cover educational expenses. So these prepaid tuition plans are exactly what they sound like: pay the current price now to receive the same services when you’re ready for them in the future.
As college tuition continues to rise, it’s easy to see how getting an education at the current price could be a really good deal. However, prepaid tuition plans aren’t as flexible as the standard 529 savings account. Most importantly, tuition credits can only be redeemed in the state where they were purchases. So if you move or your child has their eyes set on an out-of-state school, you’re going to wish that you had gone with the 529 savings plan.
What States Offer 529 Plans?
All 50 states offer standard 529 savings plans. However, only 12 states have prepaid tuition plans. Those are: Alaska, Florida, Illinois, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia, and Washington. It’s also possible to purchase prepaid tuition plans at private colleges without regard for state lines.
What Is an ESA?
The 529 savings plan is the most popular way to save for college, but ESAs are also a good option with their own unique pros and cons. While most parents aren’t likely to hit the annual contribution limit on their 529 plans, the limit for ESAs is much lower: $2,000 per beneficiary per year.
This might make ESAs seem less desirable than 529 savings accounts, but there are some unique benefits that ESAs offer. First, you get to direct where your ESA funds are invested. This is especially important if you value your own skills when it comes to selecting investments or you’re not content with the usual investments that banks will commonly choose.
The second benefit of ESA plans is that you can use the funds in them to pay for all educational expenses K-12 and beyond. 529 plans can only be used for college expenses.
What is the Difference Between a Coverdell ESA and a 529 Plan?
Choosing between Coverdell ESA plan or a 529 plan will depend on your own circumstances. Do you want flexibility when it comes to pre-college education and directing your own finances? Then the Coverdell ESA is for you. On the other hand, the 529 plan’s robust contribution cap means that you can put a lot of money into it and have those funds increase steadily as you way for the college years to roll around.
However, in choosing between 529 plans and ESAs, it’s important to remember that you don’t have to pick just one. Many parents benefit from investing in an ESA and then putting their remaining savings into a 529 plan once the ESA’s annual contribution limit is reached. This is a way to get the best of both worlds when it comes to saving for college.
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Nick Cesare is a writer from Boise, ID. In his free time he enjoys rock climbing and making avocado toast.
This post was updated November 21, 2017. It was originally published November 26, 2017.