Planning to help your child pay for college is a major undertaking. College is not cheap, but you don’t want your children saddled with student loan debt, either. A 529 plan helps offset that costly burden. But did you know there is an alternative to 529 college savings plans? Coverdell education savings accounts (ESAs) are another tax-sheltered plans that also pay qualified expenses for college. What is the difference between these savings strategies? This article compares the two so you can decide which is best for you.
The Basics of 529 College Savings Plans
- Contributions are made after tax and limits can be as low as $100k to as high as $350k depending on the sponsoring state’s regulations
- Investments are restricted to what the plan custodian offers/chooses; reallocation of assets is also restricted to two times a year
- Money grows tax free in the account
- Distributions are tax free if used for qualified plan education expenses
- There is no income limit requirement for persons making contributions
- Parents of the beneficiary retain control of the account
- Also pays up to $10k a year in tuition costs for K-12 education
In the past 529 plans only covered college education expenses. But, as of 2018, the use of these funds was extended to pay the cost of tuition (and only tuition) for lower education grades K-12. However, not all states allow tax-free distribution of 529 funds to be used for lower level education tuition, even though the federal government does. Check your state’s guidelines to be sure as this may help you determine whether you might benefit by using an alternative to 529 college savings plans or not.
Features of Coverdell Education Savings Plans
- Allows post-tax contributions with a $2k per year limit
- Offers a wider variety of investment options with no restrictions on reallocation of assets
- Income grows tax free in the plan
- Tax-free distributions provided the funds are used for qualified education expenses
- There are income requirements for contributors—find those here
- The plan beneficiary gains control of the funds when they reach 18 years of age
ESA funds are used to cover qualified college expenses such as tuition, books, computers, uniforms, and more. Since they cover the same for lower level education expenses, you can see why ESAs are an alternative to 529 college savings plans. You have more opportunities to use that tax-sheltered income for your children throughout their school years.
Additionally, you must understand the term “qualified education expenses” for both 529s and ESAs is specifically defined by the IRS. Make sure you follow their guidelines when taking funds out of either account for any reason.
ESAs Offer a Bonus as an Alternative to 529 College Savings Plans
So, the caveat of the Coverdell education savings plan is that the contribution limit is $2000 annually per child. However, if you choose to self-direct your ESA you have the potential to earn more tax-free income in a shorter time than in a 529 plan. Self-directing your ESA allows you to invest in assets not available to 529 plans—because 529 plans cannot be self-directed. So, in your quest for an alternative to 529 college savings plans, this is a noteworthy difference.
Self-directed ESA owners have access to a large pool of alternative investments like real estate, private equity, cryptocurrency, private lending and more. These assets have the potential to build wealth in the account at a faster pace than stocks, bonds, and mutual funds. You can invest in things you know and understand. This can increase the odds of successfully building the income needed to finance your child’s education. For example, investing in a rental property in a self-directed ESA can produce a larger monthly return than mutual funds may.
Now that you know a bit more about ESAs as an alternative to 529 college savings plans, we hope you can make an educated decision on which account to use.