College Savings Plans for Your Kiddos | ESA vs 529 Benefits

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I don’t claim to be a financial guru with the answer to every question about financial topics.  Instead, I’m a guy who reads and processes information.  This week, I had someone ask about college saving plans.  Today, I don’t want to talk about the best way to save for college, but instead I want to tell you why we do what we do with college savings.  If the facts that support our decision are similar to yours, then it might be wise for you to move forward with a similar plan.  If not, don’t.

Why College Savings?

Ever since our kids were first born, we committed to saving $100 per month for each of the kids for a future college savings.  We feel like education has played a valuable role in our lives, and we want to give our kids the possibility to have some help with their higher education.  That said, we do intend to encourage our kids to work through college and to contribute some of their own money.  We don’t expect $100 per month to cover everything, but we think it’s a loving start.  We may do a matching plan where we put in two dollars for every one they put in.  The details are fuzzy, as our kids are currently only 7,5, and 3, but eventually we’ll hash out our final plan.

How We Save for College: Coverdell ESA & Roth IRA

Remember, we’re in the unique situation where our kids are all dual citizens (Canadian and American), so we can’t know for sure that our kids will even end up in a school in the States.  We save through a Coverdell ESA and a Roth IRA.  I’ll explain the Roth IRA element in a moment, but first let’s compare the Coverdell ESA to a 529 College Savings Plan.

Coverdell ESA vs 529 College Savings Plan

1.  Depending on your investment background, there is less research involved in deciding to go the Coverdell ESA route.  

When you decide to do a 529 Plan, you’re just starting your decision making journey.  You now need to figure out which state has the best plan for your needs.  When you get a Coverdell ESA, you can invest in any stocks, ETFs, or mutual funds that you wish.  For some people, the idea of choosing stocks, ETFs, or mutual funds is more daunting than picking a 529 plan.  Honestly, I was lazy (or tired as a new dad), and I wanted a simple, yet effective approach.  The Coverdell ESA stood out to me as such an option.

2.  Tax impact between 529 Plans and ESA are comparable.

Neither plan offers a tax deduction on your federal return, while some 529s have a State deduction.  Both allow your investments to grow tax free and will not be taxed if used for eligible educational expenses. (ESA has a broader group of eligible educational expenses.)

3.  ESA funds can be used for elementary and secondary school expenses.

When our kids were born, we had very little idea of what the future had in store for them.  I went to a private Christian high school, and we weren’t willing to rule out the possibility that our kids might some day end up in a private elementary or secondary school.  With an ESA, the funds we’ve saved could be used towards those expenses.  However, 529 Plan funds can only be used for eligible post-secondary school expenses.

Depending on your state, you may even be able to use ESA Coverdell funds to buy school books and school supplies for home schooling students.

4.  You can invest more money in a 529 Plan.

The maximum annual contribution limit for a Coverdell ESA is $2,000 per year.  Most 529 Plans have a lifetime limit of at least $300,000.  In our case, we knew that we wouldn’t be interested in contributing more than $2,000 per year.  However, if you’re a higher income earner and wish to contribute a larger amount, there is an advantage to the 529 Plan.

5.  To contribute to a Coverdell ESA, your adjusted gross income must be less than $220,000 (filing jointly) or $110,000 (individual).  

Let’s just say that we’ve never had to worry about the income threshold.

6.  Coverdell ESA offers flexible investment options.

This was probably the biggest positive factor for us.  With a 529, you can only change your investments or 529 plan once every 12 months.  Moreover, you must choose ‘a plan’.  A Coverdell ESA allows you to make as many changes in the investment portfolio as you wish.  Since I’ve had my fair share of experience with investing, I felt like I wanted more control over what we specifically invested in.  If you’re a faith-based investor, then an ESA is clearly going to be a better option for you.

7. What if my kid doesn’t go to college? 

Coverdell ESA funds must be distributed or rolled over by 30.  If you have a Coverdell ESA fund for one of your children, then those funds must be used within 30 days of his or her birthday or rolled over to another child.  Depending on what you anticipate your kids doing in the future, this may or may not be a significant concern.  If you end up withdrawing the funds for non-eligible education expenses, the child will pay taxes on the gains (just like any other investment) and a 10% penalty.  The same happens with a 529 plan.  If you don’t use the expenses for qualified education expenses, then the earnings will be taxed as normal income, and you’ll pay a 10% penalty.

8.  Impact on Financial Aid

While there are some minor nuances to this statement, it seems fair to say that funds in a Coverdell ESA and a 529 are reported as an asset.  However, if the funds have been contributed by a grandparent in either an ESA or 529, they don’t count as an asset for financial aid purposes.

9.  Eligible Expenses

We’ve touched on this before.  The Coverdell has a much larger list of eligible expenses – elementary, secondary, and college expenses are eligible.  This includes tuition, room and board, supplies, computers, transportation, and tutoring.  The 529 Plan inclusion list is less generous.  As an example, a computer is not eligible unless it is specifically listed as a requirement for a class.

Why We’re Using a Roth IRA as a College Savings Vehicle for our Third Child

I’m not sure what the chances are that one of our kids doesn’t go to school in the States, doesn’t go to school, or gets a full tuition scholarship.  However, in our case, it’s probably better than most (perhaps for the first two reasons more so than the third).  The fact that funds in an eligible retirement savings account do not impact financial aid may be a positive factor also for this approach.  You can withdraw up to what you’ve contributed to a Roth IRA tax free without paying any penalties or taxes.

Basically, we’ve decided to diversify our college savings (I call it a hybrid approach) with our youngest. If one of the other two doesn’t use their funds on qualified education expenses, we can roll it over to the third and just keep the money in my Roth IRA if we wish.  However, if we need funds for the third, we’ll pull the appropriate amount out of my Roth IRA not to exceed my total contributions.

Essentially, instead of opening up a third ESA, we contribute an extra $100 per month to my Roth IRA.

You can read more about that strategy here.

Conclusion:

I honestly don’t think one or the other offers a ‘bad’ option.  It mostly depends on your circumstances and what you envision the future looking like.  In our case, the flexibility (of investment types and qualifying education types) of the Coverdell ESA appeals, and that’s why we continue to invest our funds there.

The biggest factor is probably just getting started.  I’d hate to see a person delay making a choice for a long time because that ultimately will be more detrimental than picking the ‘wrong’ college savings option.

I bet you knew this was coming … You could even do both.  In fact, that is the advice in this Forbes article.

Do you have any additional thoughts or advice to give to families considering the best way to save for college education?

 

Comments

  1. Gabe says

    Craig,
    I know I am showing my ignorance in this case, but are the contributions to ESA or 529 pre or post tax? And if they are post tax, like a Roth IRA, are the gains from investment also tax free, or do you pay taxes on those gains when you withdraw?
    Thanks!

    • says

      Gabe,
      For both ESA and 529 you pay taxes on them now, but you don’t pay taxes on the gains as long as they are used for a qualified educational expense.

  2. ken says

    why not just save “college” money on your own, outside of a “plan”?
    Illinois coverdale plan went broke
    the obama administration are now tampering with ideas for roth investors and there is no advantage that i can see that allows for the tax credit given to a deferred plan that offsets the future higher tax rates and inflationary threat.

    • says

      Ken,
      The reason to save within a college plan is the tax savings. You don’t pay taxes on the growth if used for education expenses. This can save hundreds if not thousands of dollars.
      To clarify a ‘coverdale plan’ cannot go broke. You own and invest all the funds. I think you’re referring to prepaid tuition.
      Sure plans for all of these things could change in the future, but I think that wisdom dictates making wise decisions today and altering those decisions in the future if there are adjustments to how the government treats them.

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