If you’re a parent, paying for college can put a serious strain on your budget, especially as tuition prices continue to climb. According to a U.S. News study, during the 2023-2024 school year, the average cost of tuition at an in-state, public four-year university was $10,662. The cost jumps even higher for students enrolled at private colleges. Saving early and often can soften some of the blow but you have to make sure you’re stashing your cash in the right place. Aside from personal savings accounts, the most common ways for parents to save for college are 529 plans and Coverdell Education Savings Accounts (ESAs).
Consider working with a financial advisor as you make plans to cover your college education expenses.
What Is a 529 Plan?
A 529 plan, also known as a qualified tuition plan, is a tax-advantaged account that you can set up on behalf of a designated beneficiary. Anyone can be a designated beneficiary including a relative, friend, yourself, etc. There are no age restrictions to consider when choosing a beneficiary.
While 529 plans are funded with after-tax dollars, contributions grow tax-free and can be withdrawn tax-free, as long as they’re used on qualified education expenses.
All 50 states and Washington D.C. offer at least one 529 plan and some states offer more than one. You don’t have to be a resident of a particular state to participate in their plan. Depending on the state, you may be able to choose between a 529 savings account or a prepaid tuition plan. With a prepaid plan, you can pre-purchase future college credits at current tuition rates.
What Is a Coverdell ESA?
A Coverdell ESA also offers some tax benefits but this type of account works differently than a 529 plan. For starters, you can only open a Coverdell account for someone under age 18, unless they qualify as a special needs beneficiary. If you open an account for a minor child, you can’t make any contributions past their 18th birthday (unless the person is a special needs beneficiary).
Like 529 plans, contributions to Coverdell ESAs are not tax-deductible. However, they do grow tax-free and can be withdrawn tax-free to pay for qualified education expenses. While 529 plans are used to save for higher education expenses in the future, Coverdell ESAs can be used to pay for K-12 education expenses, as well as higher education costs.
Unlike 529 plans, you have to meet the IRS income guidelines in order to make contributions. The IRS permits annual contributions of as much as $2,000 to a Coverdell account for for individuals with a modified adjusted gross income (MAGI) up to $95,000 ($190,000 for joint filers). The contribution limits are gradually reduced for people with MAGIs between $95,000 and $110,000 ($190,000 and $220,000 for joint filers).
Contribution Limits for 529 Plans and Coverdell ESAs
With a 529 plan, each state sets its own limit on lifetime contributions. There are no income or age restrictions. Further, the cap on annual contributions is generally about $300,000, though that varies by state. Keep in mind, however, that as of 2024, the federal government considered contributions as completed gifts that count against the $18,000 limit ($36,000 for married couples).
The annual contribution limit for a Coverdell ESA is currently fixed at $2,000 per beneficiary. The $2,000 limit is cumulative, meaning it applies to the total contributions made to more than one Coverdell account for the same beneficiary.
Making Withdrawals for College Expenses
There’s no cutoff date for when you need to begin taking money out of a 529 plan but there are specific guidelines that cover distributions. Any withdrawals you make must be used to cover qualified education expenses at an eligible institution. An eligible institution is any school that’s able to participate in federal student aid programs.
Qualified expenses include tuition, fees, books, room and board and any additional necessary costs for a special needs student. If you use the money in a 529 account for anything other than education expenses, it’s considered a taxable distribution. You’ll have to pay income taxes on whatever you take out, along with a 10% penalty.
The same distribution rules apply to Coverdell accounts with one key exception. All the assets in the account must be withdrawn within 30 days of the beneficiary’s 30th birthday, unless they’re a special needs beneficiary.
Bottom Line
A 529 plan offers higher contribution limits as well as more flexibility when it comes transferability and your range of investment choices. You also don’t have to worry about your ability to contribute being limited by your income. On the other hand, a Coverdell ESA offers similar same tax advantages, provided you adhere to the distribution guidelines. When you’re weighing your options, it helps to look at your overall savings goals and your current tax situation to see which one is the best fit.
Tips for Paying for College
- A financial advisor can help you prepare financially for college expenses. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Are you unsure of what to expect over the long term from your student loan payments? Check out SmartAsset’s student loan calculator to get more familiar.
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