Two of the most popular ways to save for future educational expenses are the 529 college savings plan and the Coverdell Education Savings Account (ESA). Both are a great way to save for future educational expenses.
The two account types are similar in many ways, but there are important differences. Many people ask whether they should contribute to one or the other. The short answer is contribute to both!
People other than parents can contribute to both 529 and ESA accounts, but my strong advice to most parents is to buy enough term life insurance and establish an estate plan BEFORE saving for education.
529 vs Coverdell: The Longer Answer
When evaluating 529 vs Coverdell accounts, the thing to remember is that both 529 and Coverdell ESA accounts are tools to save for education, but there are some major differences. Below are some of the main features and differences between the two programs.
I should note that the below is not exhaustive, but covers the factors that I consider when evaluating how to save for my own family’s education expenses. To read the all of the rules relating to 529 and Coverdell accounts, read IRS publication 970.
529 Accounts
529 Contributions
- 529 contributions are made with post-tax dollars. However, some states’ plans offer state income tax deductions for contributions.
- Contribution limits vary by state, but are generally in the hundreds of thousands of dollars and not a factor for most people.
- Only contributions below the annual gift tax exclusion ($17,000/year for 2023) do not count against one’s lifetime gift tax exemption ($12.92 million for 2023).
- The IRS does allow individuals to contribute five years of the gift tax exclusion amount without counting against the lifetime exemption. For instance, someone could contribute $85,000 to a 529 in year one, without using any lifetime gift tax exemption. Similarly, two parents could contribute $170,000 in year one.
- Contributions are not limited by one’s income.
529 Investments
- 529 accounts are limited to mutual funds (often in preset model allocations) and allocations can only be changed once per year.
529 Distributions
- Distributions from a 529 are tax-free if used towards qualified education expenses. The definitions of qualified education expenses (which differs from a Coverdell ESA’s) is quite detailed, so read the IRS guidelines for 529s. Below are a couple of areas that differ materially from Coverdell ESAs:
- Only $10,000 per year can be used towards K-12 tuition and fees, while computers, books, room and board, and other items are reserved for college expenses.
- $10,000 can be used towards student loan payments. This is a lifetime limit and not per year.
- Unlike Coverdell ESAs, there is no age limit for beneficiaries of 529s. Even an adult could open a 529 to save for their future education expenses!
Rollovers
- Beneficiaries can be changed and/or the assets rolled into a family member’s 529. Family member is of course defined by the IRS 🙂
Coverdell Educational Savings Account (ESA)
Coverdell Contributions
- Coverdell ESA contributions are made with post-tax dollars.
- Contributions are limited to $2,000 per year.
- Contributions are limited by one’s income. However, a common tax strategy is outlined below.
Coverdell ESA Tax Strategy
There is an income limitation for Coverdell ESA donations; someone cannot contribute to a Coverdell if their modified adjusted gross income (MAGI) is above $110,000 individually (or $220,000 jointly) in any tax year.
Interestingly, the IRS clarifies (in Publication 970) that “organizations, such as corporations and trusts can also contribute to Coverdell ESAs. There is no requirement that an organization’s income be below a certain level.” Many investors read this to mean that they can make an eligible contribution from their revocable trust, even if their individual or joint income is above the limit. Thus, many high-earners contribute to Coverdell accounts (regardless of their income) by making contributions through a trust.
Coverdell ESA Investments
- Coverdell ESAs can be invested in many tradable securities, such as stocks, bonds, ETFs, mutual funds, etc.
Coverdell ESA Distributions
- Distributions from a Coverdell ESA are tax-free if used towards qualified education expenses. The definitions of an ESA’s qualified education expenses (which differs from a 529’s) is quite detailed, so read the IRS guidelines for 529s. Below are a couple of areas that differ materially from 529s:
- Coverdell ESA’s cover elementary, secondary, and college expenses (unlike 529s which focus primarily on college expenses).
- Coverdell ESA funds cannot be used towards student loan payments.
- Coverdell ESAs need to be fully distributed by the time the beneficiary is 30 years old.
Rollovers
- Beneficiaries can be changed and/or the assets rolled into the Coverdell ESA of a family member under the age of 30 (with certain exceptions). Again, family member is defined by the IRS.
Q&A: Coverdell vs 529
Are 529 and Coverdells the same thing?
No, 529 and Coverdell accounts are not the same thing; they are different types of accounts. A 529 is not a Coverdell plan and a Coverdell is not a 529 plan.
Can you have a Coverdell and a 529 plan?
Yes, people can both a Coverdell and a 529 plan.
Can you contribute to a Coverdell and a 529?
Yes, people can contribute to both Coverdell and 529 accounts, even in the same year.
Should you contribute to a Coverdell or a 529 or both?
If I was going to contribute less than $2,000 per year, I would only contribute a Coverdell ESA.
Those who are contributing the maximum allowable amounts to a 529 and don’t want to maintain additional Coverdell ESA accounts, may want to just stick to 529. The rationale being: why open and maintain a Coverdell with $2,000 if opening and depositing $170,000 into a 529.
Those who want to maximize contributions and tax savings can open both a Coverdell and a 529, although I prioritize the Coverdell for the first $2,000.
Is 529 better than Coverdell?
Neither 529 nor Coverdell is “better.” The savings programs are different and the best choice will vary from person to person.
Should I used 529 or Coverdell first?
Generally, I contribute to Coverdell accounts first. However, the state tax benefits in certain states makes it more attractive to contribute to 529s first.
