529 vs. Coverdell ESA: Both are Great but Which is Better?

The most popular tax-advantaged college savings plan these days is the 529 plan. Any investment vehicle that allows assets to grow tax-free as long as distributions are used for stipulated qualifying expenses is a good thing. But there is the alternative Coverdell Education Savings Account (ESA). Which is better? Worse? Or just better for you? Let's explore.

What is a 529?

529s are set up with banks, brokerage firms or mutual fund companies by parents and grandparents who make after-tax contributions that are invested primarily in mutual funds (some plans offer ETFs, bonds, and individual stocks).

The 529 planholder (not the beneficiary) has control of when and how the money is spent even after the plan beneficiary becomes an adult. And parents or grandparents who make contributions to 529s have the ability to direct plan investments among portfolio options – and to choose or change the beneficiary.

What is a Coverdell ESA?

A more limited but tax-favored alternative to the 529 is the Coverdell Education Savings Account (ESA) introduced back in 1998 as an Education IRA. Unlike the expansive 529, the Coverdell has a more restrictive $2,000 annual contribution limit for a particular child (if exceeded, the plan beneficiary will owe a 6% excise tax every year on that excess).

Investors filing joint returns are further discouraged from setting up an ESA if their modified adjusted gross income (MAGI) is greater than $190,000 ($95,000 for single filers). Specifically, the $2,000 annual maximum is phased out for joint files with MAGIs falling between $190,000 and 220,000. Such monetary limitations represent downsides to many… and in addition, ESAs are age-limited. How so? Contributions to a Coverdell plan must end when the beneficiary turns 18, and withdrawals for qualified expenses must be distributed by the time a beneficiary turns 30. These limitations are particularly discouraging to investors with large incomes. On the other hand, these same limits appeal to prospective benefactors with lessor resources.

The 529 Flex Factor

529s offer greater flexibility than Coverdell ESAs with regard to both contributions and beneficiaries. Parents or grandparents can save for a child, grandchild, other family member, friend – even for themselves. In fact, they can even save for an unborn child and transfer the account to the child after its birth. How’s that for flexibility?

As for contributions to 529s, there is no specific annual limit. However, the total balance per beneficiary is limited to the expected amount of future qualified education expenses – usually between $235,000 to $529,000 – depending upon the state offering the plan. And the gift and estate tax treatment of a contribution to a 529 plan has its pluses and minuses.

The “minus” news first. A 529 contribution is treated as a gift to the named beneficiary for gift tax and generation-skipping transfer tax purposes. By the way, an account can only have one beneficiary, so it’s a good move to open separate accounts for each child and to tailor the investment mix to fit each child’s age. And if you’re making other gifts to the beneficiary during that same year, keep those gift tax limitations in mind.

The pluses? A contribution qualifies for the current year annual gift tax exclusion ($15,000 in 2020) meaning that most folks can make a substantial contribution without incurring the gift tax. It gets even better. If a benefactor desires to initially contribute between $15,000 and $75,000 for a beneficiary, the benefactor can elect to treat the contribution as made over a five calendar-year period for gift tax purposes. And why is this significant? It allows a benefactor to immediately utilize up to $75,000 in exclusions to shelter a larger contribution and immediately put it to work. Not so with those Coverdell accounts. In short, this provision enables a contributor to get money (and associated earnings) out of his or her estate faster than if the contributions were doled out over a five-year period.

A bit more good news. Most states let donors deduct plan contributions on their state income tax return, up to the state's limit. Again, not so with Coverdell accounts.

Financial Aid Impacts

If the student is a dependent and the 529 account is owned by either the parent or the student, the account is considered the parent's asset. Accordingly, up to 5.64% of the plan’s value will be added to the student's expected family contribution (EFC) - the money one should expect to pay for studies out-of-pocket, which influences the amount of need-based federal aid one qualifies for. This is mainly based on parent income and assets, student income and assets, household size, and the number of students attending college in the household.

If the student isn't a dependent and is the owner of the 529 account, the account is treated as the student's asset and will generally increase the student's EFC at the higher rate of 20% of the account's value.

If the 529 account is owned by someone else (such as a grandparent), it doesn't count as an asset for federal financial aid purposes. But when withdrawals are made to pay for college expenses, they'll generally count as income for the student and will have an impact on the student’s financial aid the following year.

In short, if a parent is the account owner and the child is a dependent, the 529’s savings will have a lower impact on financial aid than a different type of account opened in the child's name.

Investment Options

A 529 planholder controls the funds in the account (i.e., can invest contributions in any of a given portfolio’s several options). However, legislation that created 529 plans specifically prohibits planholders and beneficiaries from investing contributions in other than a specific plan’s provided menu of investment options. Individual stocks normally aren’t included as options because college savings plans can't act as brokers for account owners. Still, the various state plans provide ample choice and opportunity for growth.

Increasing in popularity are so-called "age-based" portfolios – not unlike Target-date funds – that automatically shift to more risk-averse investments as the beneficiary approaches an enrollment date. But remember, portfolio funds do not guarantee a return and are not insured by the FDIC.

Should monetary needs arise for purposes other than qualified educational expenses, the planholder does have access to 529 funds. Of course, taxes on earnings would be due, but no penalty would be assessed on the post-tax amount originally invested. And, if a child winds up with a scholarship, the planholder can withdraw up to the amount of the scholarship. But the earnings on the withdrawn amount would be subject to federal, state, and local income taxes. Uncle Grabby is generous, but not THAT munificent.

Qualified Expenses

529 funds can be used for tuition at a college, university, trade school, vocational school, and expenses required to participate in apprenticeship programs. Qualified expenses include room and board, fees, books, supplies, equipment, computer hardware and software, internet access and related services. Other qualified expenses include payments of student loans for college, university, trade school, vocational school, or apprenticeship programs (up to a $10,000 lifetime limit per beneficiary). Also, money can be spent on K – 12 tuition (up to $10,000 per student per year at a public, private, or religious school).

Thanks to the Covid-19 pandemic, what constitutes as qualified educational expenses under both 529 and ESA programs have been expanded to accommodate increased remote-learning.

Take Your Pick

A prospective planholder can invest in any state's 529 plan and use the funds to pay for any school in the United States or abroad so long as the school is considered an eligible education institution. If a child doesn't end up going to college, grad school, or a trade/vocational school, the planholder can shift the money to another qualified family member to use for qualified educational expenses. And as previously mentioned, the planholder can use the money for non-qualified expenses, but penalties on earnings (not contributions) would apply. A change of beneficiary of an account can be done at any time as long as the new beneficiary is a qualified family member of the original beneficiary.

In summary, whether you take the Coverdell ESA or 529 approach, there is a plan out there that fits folks of all income levels. Check the one that best fits you and your beneficiary’s needs and start saving now.