529 Plans and Coverdell ESAs – What’s the Difference?
By Agatha Schmidt, CISP, SDIP
When it comes to saving for education, individuals have a variety of options when it comes to the type of savings plan to use. Some types of savings arrangements include tax-advantaged accounts that have certain restrictions, while other types of accounts do not provide tax benefits but offer more flexibility. In this article, we will discuss the two most popular tax-advantaged ways to save for college—the 529 education savings plan and the Coverdell education savings account (ESA), and what sets them apart from each other.
529 Plan Basics and Structure
529 plans, otherwise known as qualified tuition programs, are named after the Internal Revenue Code section that governs them: Internal Revenue Code Section (IRC Sec.) 529. Created in 1996, qualified tuition programs are state-sponsored education savings plans that provide individuals with tax incentives to save for a designated beneficiary’s higher education expenses. 529 plans offer tax-free growth, similar to retirement accounts, and tax-free withdrawals as long as the withdrawals are qualified, similar to Roth IRAs. Each state that offers a qualified tuition program may offer their own unique mix of program features—their own contribution limits, allowable education expenses, and additional state tax benefits—but at minimum, programs must follow federal standards. 529 accounts are held in the name of an individual (usually a parent or guardian), for the benefit of a designated beneficiary, and anyone can contribute to the account.
Coverdell ESA Basics and Structure
Coverdell ESAs, sometimes referred to as “Education IRAs,” were created in 1997 by the Taxpayer Relief Act of 1997. These accounts provide another tax-advantaged option for saving for education expenses and are governed by IRC Sec. 530. Similar to 529 plans, Coverdell ESAs also offer tax-free growth and tax-free withdrawals as long as the withdrawals are used for qualified education expenses. These accounts, to which anyone can contribute if their income does not exceed certain limits, are generally held by a financial institution operating in the capacity of a trust or custodian and are managed by a responsible individual—an official title and role—(usually a parent or guardian) for the benefit of a designated beneficiary who must be under age 18 to receive contributions in the account. If assets remain in the account once the designated beneficiary reaches age 30, the assets are deemed to be distributed; in other words, the account can no longer be a Coverdell ESA.
Key Similarities and Differences
Aside from how these plans are structured, what else sets these two types of plans apart? Here’s a side-by-side comparison of their features.
Final Thoughts
As you can see, 529 plans and Coverdell ESAs share a few similar features, but vary in others. When considering which type of education savings account to establish, individuals should discuss their savings goals with a competent financial advisor or tax advisor. IRS Publication 970 is also a great resource for more information. It addresses the rules and qualifying education expenses for ESAs and 529 plans.
