Education Savings
IN THIS LESSON
TL;DR: in the realm of education savings, brokerage or custodial accounts may be an option, but when it comes to maximizing benefits, 529 Plans and Education Savings Accounts (ESAs) are often considered superior due to their tax advantages and lower impact on financial aid.
With the rising cost of higher education in the 1990s, Congress enacted two types of financial savings accounts specifically designed to as a way to alleviate the financial burden of higher education and promote greater access to educational opportunities for individuals and families.
Additionally, these savings vehicles aim to encourage early and consistent saving for education, thereby helping individuals better prepare for the costs associated with pursuing higher education.
Education savings accounts (ESAs), also known as Coverdell accounts, and Section 529 plans provide tax advantages and incentives to help individuals save money specifically for educational purposes, such as college tuition, fees, books, and other related expenses.
Both of these accounts provide tax-deferred growth, allowing for tax-free withdrawals if the funds are used for qualified education expenses such as tuition, books, supplies, computers, and room and board. A notable advantage is that both plans are considered the assets of the account holder, reducing their impact on financial aid compared to custodial accounts.
However, there are crucial distinctions in eligibility and contribution amounts between ESAs and 529 plans.
Coverdell ESAs
The Taxpayer Relief Act of 1997 created Education IRAs. In 2022, these were renamed Coverdell ESAs. ESAs allow after-tax contributions for student beneficiaries and allow after-tax (nondeductible) contributions to accumulate on a tax-deferred basis.
ESAs, offer another tax-advantaged education savings option. Notable features include:
Eligibility is restricted to couples with adjusted gross incomes under $220,000 (or $110,000 for individuals).
Contributions are limited to a maximum of $2,000 per year until the beneficiary’s 18th birthday.
The account must be liquidated by age 30, but the balance can be rolled over to another family member’s Coverdell ESA to avoid taxes and penalties.
ESAs provide a broader range of investment options compared to 529s.
Unlike 529s, ESAs do not have a $10,000 tax-free withdrawal cap for qualified expenses related to elementary or secondary education.
529 Plans (Qualified Tuition Program)
A 529 plan is a state-sponsored, tax-advantaged method to invest substantial assets towards education costs. Each state offers at least one 529 plan, each with its own program manager, costs, features, and investment selection. Notably:
Anyone can open a 529 account, and friends and family can contribute regardless of the account holder.
There are no income limits for opening or funding a 529 account.
Withdrawals can be used for qualified educational expenses at any eligible U.S. postsecondary institution, K-12 tuition expenses, and student loan repayments.
529 plans have higher contribution limits than other education savings accounts, with lifetime contributions varying by state.
Contribution limits allow for a significant jump-start, enabling up to $85,000 in a single year (or $170,000 for couples) without incurring gift tax, provided it’s the sole gift to that beneficiary for five years.