Coverdell ESA vs. 529 Plan: What’s the Difference?

Everybody knows that college isn’t cheap. In 2022, the average cost of attendance came in at $35,331 per year. Multiply that number by four, and it’s enough to make many parents start hyperventilating.

But try not to panic, because there are a couple of dynamic investment solutions worth exploring that can help you save for college over time. Both Coverdell Education Savings Accounts (ESAs) and 529 plans offer tax-efficient ways to invest chunks of cash over a number of years to pay for a child’s future education expenses.

That being said, it’s important to note that both the ESA and 529 come with their own unique set of pros and cons — and more dynamic options, like UGMA custodial accounts, are definitely worth checking out as a way to supplement your savings.

This guide explains what a Coverdell ESA is, what a 529 plan is, how they’re different from one another, and how you can boost your education savings using a UGMA custodial account.

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What Is a Coverdell ESA?

First, let’s take a look at Coverdell ESAs.

A Coverdell Education Savings Account (ESA) is a tax-deferred trust account that enables families to save for a child’s future educational expenses.

Coverdell ESAs were created by the US government and used to be called Education Individual Retirement Accounts (IRAs). You can use a Coverdell ESA to put cash toward a low-risk investment portfolio that appreciates over time. A major benefit is that anything you withdraw from your ESA is going to be tax-free — under certain conditions.

To make a tax-free withdrawal from your child’s ESA, it must be for a “qualified educational expense.” This generally includes education costs like tuition fees, textbooks, equipment, academic tutoring, or special needs services.

These accounts are normally used to save for a child’s future college expenses. But Coverdell ESAs can also be used to pay for expenses related to grades K-12.

In addition to tax-free withdrawals for qualified expenses, the earnings your investments generate over time in an ESA will grow on a tax-deferred basis.

Let’s say you put $500 into a Coverdell ESA that appreciated in value to reach $5,000 over a 10-year period. This means the earnings your investment has built won’t be taxed until the account’s beneficiary is officially enrolled in a post-secondary institution.

While there are a few key benefits to setting up a Coverdell ESA for a child, there are also a couple of disadvantages.

The first big disadvantage of an ESA is that you’re required to use the money in your child’s account by the time they turn 30 (or roll it over to another child’s account). If you fail to do that, you’ll have to pay both a 10% penalty fee and income tax on the funds remaining in the account.

Another disadvantage is that Coverdell ESAs have pretty low contribution limits. In 2022, you’re only allowed to invest $2,000 per child per year.

What Is a 529 Plan?

Next, you’ve got 529 plans.

A 529 plan is another tax-advantaged education savings plan designed to help you pay for a child’s future schooling. Like a Coverdell ESA, 529 savings plans are designed primarily with college expenses in mind — but in 2017, the government expanded 529 plans to cover both grades K-12 as well as apprenticeship programs.

529 plans get their name from Section 529 of the federal tax code. But each 529 plan is actually administered by state governments. This means that each 529 plan is slightly different. Anyone can set up a 529 account for a child, but it’s normally parents or grandparents that set one up for a beneficiary under age 18.

In some US states, the person (or people) funding an account might qualify for state tax deductions.

Just like a Coverdell ESA, all the money you pay into a 529 plan grows on a tax-deferred basis until you withdraw it. As long as you’re withdrawing the funds for educational expenses, you won’t get taxed on them. But unlike Coverdell ESAs, 529 plan administrators stick to a more rigid IRS definition of a qualified expense.

This means that 529s can normally only be used for tuition fees, admin fees, and on-campus accommodation fees.

If you’re withdrawing money for a child’s college expenses, you’re not going to be capped on withdrawals. If you’re withdrawing for K-12 expenses, your tax-free withdrawals will be capped at $10,000.

Unlike Coverdell ESAs, there aren’t any annual 529 plan contribution limits. But if you contribute more than your annual gift tax exclusion ($16,000 per child per year in 2022), you’ll need to report that gift to the IRS, and it’ll count against your lifetime gift tax exemption (currently $12.06 million).

Every state gets to set its own aggregate contribution limit for its 529 plans. These range from $235,000 to $550,000.

There are two main types of 529 plans: college savings plans and prepaid tuition plans.

College savings plans

College savings plans are the most popular type of 529 account. When you set up a college savings plan, you contribute money that is then normally invested in a portfolio of mutual funds.

You often get to choose between a number of low-risk portfolios, and how that portfolio performs will dictate how your account balance grows over time.

529 college savings plans can be used to pay qualified expenses for both college and grades K-12.

Prepaid tuition plans

Prepaid tuition plans, which are offered by some states, let you lock in a tuition price at current rates for your child. This means you stand to save a bit of money in the future, as tuition rates tend to increase annually.

Unlike a college savings plan, prepaid 529 plans can’t be used for educational expenses associated with grades K-12. They also can’t be used for room and board.

Coverdell ESA vs. 529 Plan: What’s the Difference?

Now that we’ve covered how both the Coverdell ESA and 529 plan work, let’s break down the key differences.

Contribution limits

The biggest difference between ESAs and 529 plans is their annual contribution limits.

The Coverdell ESA has an annual cap on the amount of money you’re allowed to contribute. At present, the IRS limits contributions to $2,000 per child per year.

If you’ve invested up to that cap annually for a number of years, you could probably save enough to cover fees at a public in-state school. But if you’re saving for a future Harvard grad, these contribution limits are going to hinder you.

On the other hand, a 529 plan doesn’t have an annual contribution limit. Instead, it only has an aggregate limit — and it’s pretty high, too. This limit ranges from $235,000 and $550,000, but it depends on the state your 529 is set up in. This limit shouldn’t hinder your ability to pay for a child’s college tuition.

That being said, your annual contributions could be limited by the IRS Gift Tax. If you contribute above your annual limit of $16,000 per child per year, the overspill amount will get counted against your lifetime limit, and you may need to pay tax on it.

Qualified expenses

Another key difference is what you can use your investment for.

A 529 savings plan only lets you make tax-free withdrawals to pay for qualifying education expenses at higher education institutions and some K-12 expenses. 529 plans stick to the IRS definition of qualified expenses, which is pretty rigid. You’ll normally only be able to use a 529 to pay for tuition fees, admin fees, and university-managed accommodation.

Coverdell plans use a wider definition of qualified expenses. You can use a Coverdell ESA to pay for a private K-12 or higher education, and withdrawals are normally tax-free for tuition and fees, textbooks, supplies, equipment, and room and board.

Savings guidelines

The final key difference between ESAs and 529 plans is their savings guidelines.

A 529 plan can be used to pay for the college education of your first child — and then any leftover money you have can be used to pay for your next child. This flexibility means you won’t get penalized for saving too much or not getting the chance to use all your savings.

With a 529 plan, you can also deposit gifts from friends and family, allowing your child’s investment to grow faster.

With a Coverdell ESA, you’re only saving for a specific child. You can no longer make contributions to the account after the child’s 18th birthday (even if they’re still in high school), and there are normally income guidelines that dictate who can qualify for an ESA.

Coverdell ESAs don’t normally allow friends or family to gift into your child’s ESA.

What’s the Best Alternative to the ESA and 529?

Whether you choose a 529 plan or an ESA to save for your child’s future, you may want to pursue a supplementary investment vehicle alongside that savings account to make sure you’ve got all your bases covered.

This is where a UGMA custodial account comes to the rescue.

So, what’s a UGMA?

A Uniform Gifts to Minors Act (UGMA) account is a custodial investment vehicle that lets you save for a child’s financial future. When you set up a UGMA account for a child, you, as the adult, are responsible for managing everything in that account for the named beneficiary. Until the child reaches the age of majority in their state (in most states, that’s either 18 or 21), you’re going to be the account’s custodian.

The key benefit of a UGMA account is that, although you’re responsible for managing the account, all of its assets are still the legal property of the child.

This can lead to solid tax savings for the adult who is doing the saving. That’s because the IRS taxes all of the unearned income a custodial account generates at the child’s lower tax rate — at least up to a certain threshold. In 2022, that threshold is $2,200.

The top two advantages of setting up a custodial account are that their withdrawal rules aren’t limited, and they don’t have contribution limits.

Unlike a 529 plan, which has rigid withdrawal rules, the child beneficiary of a UGMA account can use that money for whatever they’d like to after they reach the age of majority. This means that if your child grows up and decides they don’t want to go to college, they can still use the nest egg you’ve built for them to chase their dreams.

Meanwhile, UGMA accounts don’t have low contribution limits like Coverdell ESAs. You can place as much into a custodial account as you’d like. You just have to be aware of your gift tax allowance. But unlike the ESA, multiple people can contribute to a UGMA account. This means that you, your parents, your brothers, and your sisters could each put up to $16,000 into a custodial account without having to pay taxes on those gifts.

Translation: A custodial account is a flexible and tax-efficient way to save for a child’s future education. That’s why so many parents choose to set up a custodial account rather than an ESA or a 529. If you want to maximize the tax benefits of saving for college using a 529 or ESA plan and benefit from the flexibility of a UGMA, you can even opt to set up both.

Conclusion

At the end of the day, the Coverdell ESA and the 529 plan both have their own pros and cons. It’s important to do your research to understand which plan is right for you — although it might make sense to check out other investment options, too.

While a 529 plan or ESA is a great way to save for your child’s future, these plans are not financial silver bullets. That’s why, for a lot of families, it makes sense to invest in a UGMA account.

With a UGMA account, you’re able to invest in a child’s financial future without having to worry about contribution limits and tough withdrawal rules. Better yet, you can get your friends and family involved to build that nest egg up even quicker.

So, are you ready to start investing for your child’s financial future? Download the EarlyBird app now.

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