Guide to 529 Savings Plans vs ESAs

By Rebecca Lake · June 13, 2024 · 9 minute read

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Guide to 529 Savings Plans vs ESAs

Saving for college may help minimize the need to take out student loans to pay for school. Education Savings Accounts (ESAs) and 529 plans both allow you to save on a tax-advantaged basis, but there are some key differences in how they work.

Comparing the features of Education Savings Accounts vs. 529 plans, as well as the pros and cons, can help you decide which one is right for your needs.

Education Savings Accounts (ESAs) vs 529 Savings Plans

Education Savings Accounts and 529 plans are both designed to help you save money for qualified education expenses. In other words, they’re accounts you can use to save money for college, as well as potentially other types of schooling.

These plans can help you avoid a situation where you’re using retirement funds for college. On some levels, they’re quite similar but there are notable differences between the two options, as well.

Similarities

When putting an ESA vs. 529 plan side by side, you’ll notice that they have some features in common. Here’s how they overlap:

•   Contributions to ESA and 529 plans, made with after-tax dollars, grow on a tax-free.

•   Withdrawals are tax-free when funds are used to pay for qualified education expenses, as defined by the IRS.

•   You’re not limited to using ESA or 529 plan funds for college; both allow some flexibility in paying for elementary and secondary school expenses.

•   Non-qualified withdrawals from ESAs and 529 plans may be subject to taxes and penalties, with some exceptions.

•   Both plans allow you to transfer savings to another beneficiary if your student opts not to go to college or there’s money remaining after paying all of their education expenses.

Differences

The differences between a 529 plan vs. ESA largely center on who can contribute, contribution limits, and when funds must be used. Here’s how the two diverge:

•   ESA contributions are limited by the IRS to $2,000 per child, per year, while 529 plans typically don’t have annual contribution limits.

•   Income determines your ability to contribute to an ESA but doesn’t affect your eligibility to open a 529 plan.

•   ESA contributions are only allowed up to the beneficiary’s 18th birthday unless they’re a special needs beneficiary.

•   Remaining funds in an ESA must be withdrawn by the beneficiary’s 30th birthday unless they’re a special needs beneficiary.

•   529 plans have no age limits on who can be beneficiaries, how long you can make contributions, or when funds must be withdrawn.

Education Savings Account

529 College Savings Plan

Income Limits Individuals must be within MAGI limits to contribute Anyone can contribute, regardless of income
Annual Contribution Limit $2,000 per child None, though contributions above the annual gift tax exclusion limit may trigger the gift tax

Contributions are subject to lifetime limits imposed by each state, but these are much higher, typically ranging from about $300,000 to $500,000

Eligible Beneficiaries Students under the age of 18 or special needs students of any age Students of all ages, including oneself, one’s spouse, children, grandchildren, or other relatives
Investment Options May include stocks, bonds, and mutual funds Typically limited to mutual funds
Tax Treatment of Withdrawals Withdrawals for qualified higher education expenses are tax-free; all other withdrawals are subject to tax and penalties Withdrawals for qualified higher education expenses are tax-free; all other withdrawals are subject to tax and penalties
Qualified Expenses Withdrawals can be used to pay for elementary, secondary, and higher education expenses, including tuition, fees, books, and equipment Withdrawals can be used to pay for qualified higher education expenses, including tuition, fees, books, and equipment, as well as K-12 tuition, eligible apprenticeship expenses, and qualified education loan repayments
Required Distributions All funds must be withdrawn by age 30 or rolled over to another beneficiary, unless the beneficiary is a special needs student Funds can remain in the account indefinitely or be rolled over to another beneficiary
Financial Aid Treated as parental assets for FAFSA purpose Treated as parental assets for FAFSA purposes

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What Is an ESA?

An Education Savings Account, now known as a Coverdell Education Savings Account (ESA), is a trust or custodial account intended for education savings. ESAs allow flexibility since you can use them to save for college but the IRS also allows withdrawals for qualified elementary and secondary school expenses.

Pros and Cons of ESAs

If you’re considering an ESA versus 529 plan, it’s important to consider the advantages and potential downsides. While ESAs offer tax benefits, there are some limitations to be aware of.

Pros:

•   Tax-deferred growth. Funds in an ESA grow tax-deferred, meaning you pay no tax on the earnings in the account until you begin making withdrawals.

•   Tax-free distributions. As long as the money you withdraw is used for qualified education expenses, you’ll pay no tax on ESA funds.

•   Multiple uses. Money in an ESA can pay for a variety of expenses, including college tuition and fees, books and supplies, and room and board for students enrolled at least half-time. Parents of elementary and secondary school students can use the funds for private school tuition, academic tutoring, and school-mandated costs of attendance, such as uniforms or room and board.

Cons:

•   Contribution limits. You can only contribute $2,000 per year to an ESA, which is well below the amount you could save in a 529 plan.

•   Income caps. Single filers with a modified adjusted gross income exceeding $110,000 and married couples filing jointly with a MAGI over $220,000 cannot contribute to an ESA.

•   Age restrictions. You can’t contribute anything to an ESA once the beneficiary turns 18 and they must withdraw all remaining funds by age 30. Those distributions are subject to tax.

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What Is a 529 Savings Plan?

A 529 savings plan or Qualified Tuition Program (QTP) is a tax-advantaged account that you can use to save for education expenses. All 50 states offer at least one 529 account and you don’t need to be a resident of a particular state to contribute to its plan.

In addition to 529 savings plans, some states offer 529 prepaid tuition plans. These plans allow you to “lock in” rates, offering some predictability when it’s time to pay for your child’s college tuition.

Pros and Cons of 529 Savings Plans

There may be a lot to like about 529 savings plans but like ESAs, there are also some potential downsides to consider.

Pros:

•   Contribution limits. There are no IRS limits on annual contributions to a 529 plan and states can determine where to set aggregate contribution limits.

•   Eligibility. One of the advantages of a 529 savings plan is that anyone can contribute, regardless of income, and there are no age restrictions on who can be a beneficiary.

•   Tax benefits. Earnings grow tax-deferred and qualified withdrawals are tax-free.

•   Funds use. 529 plan funds can be used to pay for qualified college expenses, K-12 private school tuition, qualified education loan repayment, and eligible apprenticeship expenses.

Cons:

•   Tax penalties. Non-qualified withdrawals are subject to a 529 withdrawal penalty and taxes.

•   Tax breaks. There are no federal tax deductions or credits for 529 plan contributions and while some states offer them, they may only be available to residents.

•   Investment options. Compared to ESAs, 529 education savings plans may offer fewer investment options; it’s also important to consider the investment fees you might pay.

Which Savings Plan Is Right for You?

Deciding when to start saving for college for your child is the first question to tackle; where to do it is the next. Whether you should choose an Education Savings Account vs. 529 plan may hinge on your eligibility for either plan and your ability to save.

You might choose an Education Savings Account if you…

•   Are within the income thresholds allowed by the IRS

•   Would like a broader range of investment options to choose from

•   Are comfortable with control of the account being transferred to the beneficiary when they turn 18

On the other hand, you might prefer a 529 plan if you…

•   Want to be able to contribute more than $2,000 a year to the plan

•   Don’t want to be limited by age restrictions for contributions or withdrawals

•   Qualify for a state tax deduction or credit for making 529 contributions

You may also lean toward a 529 if you want more options concerning how you use the funds. While you can withdraw money from a 529 to repay student debt or pay for apprenticeship fees and supplies, you can’t do that with an ESA.

If you’re shopping for an ESA or 529 plan, consider the type of investment options offered and the fees you might pay. You might start with your current brokerage to see what college savings accounts are available, if any.

The Takeaway

Saving for college early and often gives you more time to grow your money through the power of compounding interest. If you’re torn between an Education Savings Account vs. 529 plan, remember that you don’t necessarily have to choose just one. You could use both to save for education expenses if you’re eligible to do so. Just remember to prioritize saving in your own retirement accounts along the way so that you’re not shortchanging your nest egg.

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FAQ

Is it better to put money in a 529 or an education savings account?

One of the main advantages of a 529 savings plan is the opportunity to save more than you could with an ESA. At most, you can contribute $36,000 to an ESA, unless your student is a special needs beneficiary. States can offer 529 plans with aggregate contribution limits of $500,000 or more.

What is the downside of 529 accounts?

If you take money out of your plan for anything other than education, you’ll face a 529 withdrawal penalty. The penalty is 10% and you’ll also have to pay tax on the earnings you withdraw, which could make a non-qualified distribution expensive.

What happens to 529 if the child doesn’t go to college?

If you opened a 529 savings plan for your child and they decide not to go to college, you can transfer the money to a different beneficiary. You may select yourself as the beneficiary or choose your spouse, another child, a grandparent, or another relative.


Photo credit: iStock/kate_sept2004

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