529s vs ESAs: Exploring College Savings Plans

It’s no secret that the cost of a college education has skyrocketed, and that more and more individuals are incurring significant amounts of debt in order to pay for their degrees, to the tune of about $1.5 trillion. Education is so expensive now that even with combined funding through scholarships, grants, and college savings, many individuals still end up having to take loans. It makes sense that parents and those who are thinking about starting families have college savings on their minds. No one wants their kids to graduate in debt. Fortunately, if you have children or plan to have children someday, you can start saving for tuition early with special status investment accounts designated for educational expenses. 

You have two good options for college savings plans, 529s and ESAs. 529 is a shortened description of an IRS investment provision in Section 529. ESA is short for Coverdell Educational Savings Accounts. Contributions made into both types of accounts are after-tax, like an IRA. Both have a maximum transactional contribution, meaning the amount that can be deposited into an account at a time is limited. However, 529s are widely used by the states and are administered at the state level, whereas ESAs can be set up at any brokerage and most financial institutions. There are some notable differences between the two plans, however, to be aware of. Here’s what you need to know about 529s vs ESAs.

What types of investments can go into 529 vs ESA accounts?

The most that can be added annually to ESA savings for a beneficiary is $2000. It’s important to note that this isn’t an account value limit; the restriction is per beneficiary. The limit on a 529 plan is much higher if the value of the account doesn’t exceed the state limit. States commonly have a maximum account balance of $400,000 or more to allow for the costs to cover 4-year college and post-graduate education.

It is also important to note that Section 529 plans can be used for primary and secondary education at public, private, and religious institutions, up to $10,000 per year, but ESAs can only be used for college expenses. This allowance for K-12 was a newer provision added to the existing legislation in 2018, and some states even offer additional tax benefits for families who use their 529s to help pay for K-12 education.

The IRS does pre-determine the types of investments that can go into 529 vs. ESA accounts. 529 accounts are limited to mutual funds, exchange-traded funds, and target date funds. Investments in target-date funds become more conservative as they near maturity date.

This will make timing an important consideration. For example, if the money may be needed to pay for tuition expenses at a parochial school within 5 years of opening an account, investments should all be low risk. At the opposite end of the investment scenario, if the account ages over 18 years or so, investments can begin with higher risk and should become more conservative as the beneficiary nears his or her college years. 

The IRS recommends that you check your plan’s Offering Circular or Disclosure Statement for any specific restrictions on investments, but an ESA will most likely allow you to invest in virtually any stock, bond, or mutual fund you want as long as the $2000 annual limit is adhered to. Some investment accounts are considered also considered “static” and, in the case of 529s, account holdings can only be changed twice a year.     

Estate and tax benefits

The account holder can change the 529 beneficiary to whomever he or she chooses. Having 529 accounts also comes with the benefit of tax-free capital gains on the investment. The plan’s assets are generally not counted as part of the plan holder’s estate, so 529 plans confer estate tax benefits. However, if withdrawals are not used for approved expenses such as tuition or room and board, the account holder is subject to a 10% penalty tax.

Prepaid tuition plans

If you opt for a 529 plan, be aware that there are two types. We’ve already discussed the college savings plan, but there is also a prepaid tuition plan. Designated universities can agree to allow a plan holder to prepay for a semester or more of education at the current tuition price. This protects the plan holder from tuition increases in the future. This type of plan has lost popularity, however, because it is so restricted. Pre-paid tuition accounts lose value if the beneficiary wants to withdraw funds to pay for tuition at a university that isn’t on the designated list. They also tend to have stricter limitations on what expenses they can cover, and they may impose other limits such as residency requirements and age caps.

Maximize your tax-free college savings

Consider investing in both the 529 and the ESA for your children’s college savings. SD Mayer wealth managers can set-up an ambitious college investment plan for you in the lower contribution Cloverdale ESA. You could also combine this option with the 529 plan driven by ETFs, mutual funds, and investment grade products with long-term stability. 

If you think this might be tricky to navigate, we can help, and you can feel confident knowing that your child’s education is in expert hands. We will not only ensure that when it’s time to pay for college tuition you will know how to make tax free, worry free withdrawals. But, we’ll take a broader look across your assets or your estate to try and reduce your overall tax liability well into the future. 

At SD Mayer, we want to know what’s most important to you about college savings planning. We understand that you’re investing in your family’s future, and we know how to help you to reach that goal. Contact us today for more information.

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