You’re finally at the place where you can start putting money away for your kids’ college. But now you’re faced with a decision: Where should you put that money?
Options vary depending on your income and your family’s needs, but for most people the choice boils down to one of two options: an Education Savings Account (ESA) or a 529 plan.
How Are 529 Plans and ESAs Alike?
When you open a 529 or an ESA, you must name a beneficiary—the child for whom you’re saving the money. With both plans, you can transfer that money to a different person so they receive the money without paying taxes on the money as long as they’re related to the original beneficiary. So if you’re saving for your kids’ college and they get full scholarships, you can give the money to their kids. Talk about leaving a legacy!
When it comes to the FAFSA (Free Application for Federal Student Aid), both the 529 and ESA are treated the same. Neither account will hurt your children’s chances of getting federal financial aid, including grants. There are some special rules when it comes to filing the FAFSA, so make sure you start on it early!
With both plans, the money grows tax-free and isn’t taxed when you take it out—as long as it is used for qualified expenses. If you use it for a nonqualified expense (explanation below), you’ll get hit with federal taxes and a 10% penalty, no matter which program you chose. The government is serious about using this money for educational purposes!
What Are the Features of a 529?
A 529 plan (named after a section of the IRS code) is an investing option that almost every state offers. Most states allow you to choose between two or three investing portfolios, but you cannot choose individual mutual funds from within those portfolios. You can reallocate the money within the portfolio you choose, but only twice a year.
Here are some other features of a 529:
- There is no age limit for distributions (in most states). If your 32-year-old decides to go back to school, they can still use money from a 529.
- Withdrawals can be used only for college expenses. You can use money for tuition, room and board, and supplies (think computer, books, special needs, etc.).
- There are no income restrictions. Anybody can contribute to a 529.
- Contributions are limited to $14,000 a year. Lifetime limits to giving are determined by the individual 529 program; some allow $300,000 or more per student.
- Withdrawals are tax-free (federal).
- Non-qualified withdrawals are taxed. The person who received the distribution pays the tax on the money taken out.
Of course, there are some exceptions and fine print with every government program, but there’s no need to bore you with those right now. Check out the details before you choose and be sure to ask your financial pro questions until you understand everything.
What Are the Features of a Coverdell Education Savings Account (ESA)?
Sometimes called a Coverdell ESA (named for the guy in Congress who pushed for it), an ESA differs from a 529 plan in a few ways. The biggest difference is the way you invest the money. With an ESA, you can choose almost any kind of option—stocks, bonds, mutual funds. You can’t do that with a 529 plan. You can also change the investments to different places any time you want (also not an option with a 529).
Here are some other features of the ESA:
- Money must be used by the beneficiary by age 30 or given to another family member to avoid taxes and penalties.
- An ESA can be used for primary and secondary school, not just college expenses.
- An ESA has income restrictions. The ability to contribute phases out for incomes between $95,000 and $110,000 (single filers) and between $190,000 and $220,000 (married filing jointly).
- Contributions are limited to $2,000 per child, per year.
- Non-qualified withdrawals are taxed; the pays the tax.
Again, read the fine print before you invest. You don’t want to get hit with a penalty or tax because you didn’t know the particulars of your plan.
Should I Go With a Prepaid Tuition Plan?
The simple answer is no. That’s because over the long haul, you’d get more return by investing that money instead of locking in a tuition rate. Not only that, but with most prepaid tuition plans, the state will only refund the principal (not any interest you’ve earned) if your child decides not to go to college. And you can’t pass along that money to another sibling.
Here’s the bottom line: You want to stay in the driver’s seat with your money, whether it’s in an ESA or your own retirement fund. If you go with an ESA, you have more control over how you invest it, but 529 plans are beginning to offer more flexibility.
Here are the 529/ESA pros and cons again at a glance:
- No age limit for using it
- Withdrawals for college expenses only
- No income restrictions
- Contribution limit of $14,000/yr
- Withdrawals tax-free
- Non-qualified withdrawals taxed
- Money must be used by age 30
- Can use for primary/secondary ed.
- Income restrictions
- Contribution limit of $2,000 per child/yr
- Non-qualified withdrawals taxed
No matter what option you choose, you can’t ever go on autopilot. And make sure you talk with an investing professional before you deposit any money. They’ll know the particular options in your state, including any tax breaks you’d get on the state level, and they’ll give you more confidence as you make your decision. Remember, you never want to invest in anything you don’t understand.