Although there are a few tax-advantaged ways to save for higher education expenses, the two most prominent are found in sections 529 and 530 of the Internal Revenue Code: Qualified Tuition Programs (a.k.a. “529” accounts) and Education Savings Accounts (a.k.a. a “Coverdell” accounts). Each has certain advantages and disadvantages, depending upon your income and goals.
Available since 1998, ESAs were originally known as Education IRAs. Like 529s, money withdrawn from ESAs for qualified educational expenses is tax free, but unlike 529s, ESA accounts may be used to fund K-12 education expenses. Another advantage of ESAs is that the range of possible investment options is very broad, whereas 529s are typically limited to a few different mutual funds. Beginning in 2012, the contribution limit was fixed at $2,000 per year for ESAs. Finally, ESAs become the property of the child when the contribution is made – similar to a custodial account.
529s are appealing for several reasons. While eligibility for ESAs phases out for households with adjusted gross income of between $190,000 and $220,000, savers of all incomes are able to contribute to 529s. Unlike ESAs, most states offer a tax deduction for contributions to 529 accounts, and a few states even offer tax credits. Indiana’s state income tax credit is perhaps the most generous: 20% on the first $5,000, with a $1,000 maximum credit. The financial impact is as though you contribute $4,000 and the state of Indiana matches 25%. 529s also allow far higher contributions, subject to gift tax limitations.
So, which is better? Here are some situations where either an ESA or a 529 might be more suitable for you:
- If your adjusted gross income is greater than $220,000, an ESA is not an option for you.
- If you live in a state that offers a deduction – and certainly a credit – for 529 contributions, you need to factor the additional financial benefit into the total potential “return” on your investment. Generally 529s will make more sense in this scenario.
- If the money is allocated for private, K-12 education instead of college, a 529 is not an option.
- If you are uncertain whether a child will attend college, a 529 offers the option to reclaim the assets (with a penalty & taxes) and the account value can be transferred to siblings.
There are a couple of additional nuances to be aware of when choosing between a 529 and an ESA:
While the earnings in both grow tax free, the actual benefit may be more limited in an ESA than in a 529. This is because the shorter investment horizon for K-12 expenses vs. college expenses suggests a more conservative portfolio: a contribution made this year for private school tuition expenses next year is probably best allocated to cash. The real power of tax-free investing arises in 529s when the time to withdrawal is 10, 15, or 20 years away.
ESAs are popular with financial advisors because they can choose from a much wider range of products. Although, if investment alternatives are a major factor, you might consider using another state’s 529: most states have 529 plans, which are open to residents of any of the other 49 states.
Unless you’re saving for private high school and your child is very young, ESAs may not hold much appeal, particularly in this interest rate environment. 529s, on the other hand, offer significant benefits for college and graduate school savers. If you have questions about saving for future education goals, and how to set up the account that’s right for you, we welcome your call.