For many students and their loved ones, bracing for college expenses can feel like a battle they’ll never be ready to fight. A recent report by the Institute for Higher Education found that working-class students could only afford to attend between 1% and 5% of the 2,000 schools studied. In contrast, students from the upper-middle class could afford a whopping 90%.
It’s an unfortunate disparity and one that shows no signs of getting better anytime soon. A separate report by New America found that over half of four-year institutions studied required the financially neediest students to pay over $10,000 – equating to more than one-third of their family’s annual income. It can be an intimidating task to save for college, but savings plans can help ease some of the burden.
Of all savings plans, however, perhaps the two most popular types are the Coverdell Education Savings Account and the 529 Plan. Both are relatively tax-free, have the flexibility to be applied to K-12 education as well as higher education, and offer a safe way for your earnings to gradually accumulate and compound without gouging your savings altogether. However, there are some key differences you’ll want to know before committing to either. Keep reading for a comparative look at each plan.
Coverdell Education Savings Account
A Coverdell Education Savings Account (ESA) is one that allows the account owner to make tax-free investments and tax-free withdrawals for education expenses. The Investment Company Institute defines such qualified expenses as tuition and fees, uniforms, special needs services (if necessary), and supplies like books and technology. Whereas a 529 plan can only cover these in college, a Coverdell ESA can cover them throughout the entirety of K–12 education. Room and board, transportation, and non-special need medical expenses are generally not covered as qualified expenses under a Coverdell ESA.
Parents, grandparents, other relatives, organizations, non-blood related friends and loved ones, are all able to contribute to a Coverdell ESA plan, as well as the child beneficiary themselves. Annual contributions exceeding the $2,000 limit (which may be paid by one or across multiple donors depending on income level), or money allocated to non-qualifying expenses may be subject to a ten percent tax penalty.
A Coverdell ESA is often provided and set up through the financial institution of your choosing; application parameters may vary, so look them up on your respective institution’s website or contact a representative for more information.
Investments into a Coverdell ESA may be made until the beneficiary reaches the age of 18. Invested funds must be distributed before the beneficiary turns 30, unless they are special needs or the account is transferred to another qualified family member. These investments do not have to be localized to your state or your state’s academic institutions and may include stocks, bonds, and other mutual funds outside your state.
With all of this information in mind, how do Coverdell ESAs stack up against 529 plans?
Sponsored by public state governments and state education institutions alike, 529 plans allow account owners to set aside earnings for a beneficiary’s education costs. Like a Coverdell ESA, investments directed toward qualified education expenses are not taxed. In fact, they may actually advantage the account owner to receive tax breaks when that time of year rolls around.
There are two types of 529 plans available to Americans: Prepaid Tuition Plans and Education Savings Plans. A prepaid tuition plan is fairly self-explanatory; it allows the account owner and beneficiary to pay for qualified expenses at participating institutions, at their current prices, without being concerned about inflation and subsequent tuition increases.
Unlike Coverdell ESAs, Prepaid Tuition Plans are primarily sponsored by state governments and are generally contingent on the beneficiary attending a local institution in-state. Prepaid Tuition Plans are more commonly eligible at public institutions, but if you’re seeking an alternative, the 529 Private College Program may be better suited for your needs.
The appeal of a Prepaid 529 Plan is obvious: account owners can pay for their loved one’s tuition ahead of time, ahead of the curve of any inflation or price hikes. On the other hand, 529 Education Savings Plans offer full ownership and control over a beneficiary’s account, an annual $10,000 contribution rate through K-12 and higher education (minus additional non-tuition expenses through the K-12 period), and a wider range of investment options like mutual funds, ETF portfolios, and additional bank products.
While one plan is not inherently better than the other, one may be more suited to your needs. To better evaluate which 529 Plan is best for you, you may find this guide by the Securities and Exchange Commission helpful. How exactly do both 529 plans stack up to a Coverdell ESA?
What’s The Difference?
As you might’ve already gleaned from the above two descriptions, Coverdell ESAs and 529 plans have their fair share of similarities, but there are some key differences.
A Coverdell ESA can be put toward a larger set of qualified expenses throughout the entirety of a child beneficiary’s educational career, albeit at the detraction of a lower ($2,000) annual contribution rate.
On the other hand, a 529 Education Savings Plan offers the freedom to contribute more money ($10,000 a year) throughout the entirety of a person’s educational career, but can only be used toward qualified higher education expenses.
A 529 plan is not subject to the age limits of a Coverdell ESA. However, asset reallocation to another account is limited to two transfers per year, and investments must generally be limited to bonds, mutual funds, and bank products offered by the local financial institution providing the plan.
A Coverdell ESA’s assets belong to the beneficiary, while the account owner controls a 529 plan’s assets. While this may detract some, it may be a useful safety net in case the beneficiary doesn’t go to college.
With a Coverdell ESA, the owner can change the beneficiary if they choose not to use the assets for college when they reach adulthood. Still, there’s no guarantee that the new beneficiary will apply those assets to their education. However, there’s also no guarantee that a Prepaid 529 Plan will fully retain its value. If the prepaid plan is sponsored by a state government, and not guaranteed, you may lose some or all of your money if the sponsor experiences funding cuts.
Both investment plans are largely tax-free, but neither plan is particularly favorable toward federal financial aid eligibility. Granted, it’s debatable whether these plans yield any negative impact toward eligibility. However, it’s known that both will only have 5.64% of their value included in the student’s Expected Family Contribution (EFC) on their Free Application for Federal Student Aid (FAFSA) application.
Ultimately, there is no specific plan that can be deemed “better” than the other, as the advantages and disadvantages depend on matters like socio-economic status and personal priority. If you’re uncertain about those priorities, you may want to speak about them further with a financial advisor.