Choosing the Best Education Savings Plan: Weighing the Pros and Cons of 529 and ESA to Suit Your Needs

Giving your children or grandchildren a college savings account is an invaluable present that can aid them in graduating from college with zero debt, allowing them to commence constructing their future on a strong foundation. Whether your little one is 8 weeks old or 8 years old, it's paramount to begin depositing money into the account as soon as you can. The question is, where should you put that money?

Choosing the best account option depends on your income and family's requirements. However, in this article, we're going to compare the two most popular accounts: Education Savings Account (ESA) and a 529 plan. But before that, we need to ensure that you understand the features of each plan.

What Is a 529 Plan?

A 529 plan is a state-operated, tax-favored account that allows you to save money for educational expenses. You can create a 529 plan for your child or grandchild and designate them as the beneficiary. This implies that the individual can use the funds to pay for college, among other things. The 529 plan isn't just an ordinary financial account; it's an opportunity to transform your family's financial future.

There are two primary types of 529 plans: prepaid plans and savings plans. A prepaid plan guarantees the current rate of tuition when your child or grandchild is born, allowing them to avoid the significant price hike due to inflation by the time they head off to college in 18 years. On the other hand, the 529 savings plan enables you to select a pre-determined investment portfolio that you can use to grow money for your child's future educational costs. You can reallocate the funds within the portfolio you choose, but only twice a year.

In this article, we're going to focus on the savings plan because investing your money has a better long-term return compared to locking in a tuition rate with the prepaid plan. Additionally, with most prepaid tuition programs, if your child decides not to attend college, the state will only refund the principal (not any interest earned), and you can't transfer the funds to a sibling of the beneficiary.

Now, let's examine the specifics of the 529 plan.

The Salient Features of a 529 Savings Plan:

It's a tax-favored account that allows the beneficiary to utilize the funds for both college and K-12 educational expenditures. Each 529 plan varies from state to state. There are no annual contribution limits, but you must pay gift tax if you contribute more than $17,000 in 2023. There's no age limit for distributions in most states, meaning that if your 32-year-old child decides to go back to school, they can still use money from a 529. There are no income restrictions for contributing to a 529. Moreover, growth and withdrawals aren't subject to federal income tax when used for qualified educational expenses, such as tuition and books. If you want to use money in a 529 plan for non-educational expenses, you can. It's your money! But nonqualified withdrawals will incur taxation and a 10% penalty payable by the recipient. Lastly, the SECURE Act, established in December 2019, created new qualified expenses for 529 savings plans, including apprenticeships, private K-12 tuition, and repayment of up to $10,000 of student loans for the beneficiary and their siblings.

Before selecting a plan, make sure to do your research as Uncle Sam and you both love fine print! Don't limit yourself to your state's 529 plan, shop around for better investment options and lower fees from other states. We suggest seeking guidance from an investment pro who understands these plans thoroughly.

Let's talk about Coverdell Education Savings Account (ESA). This trust or custodial account is named after the guy in Congress who promoted it. It allows you to save and grow money for educational purposes. Though akin to a 529 plan, it has two substantial differences and more limitations. Firstly, the contribution limit per child per year is only $2,000, while there is no limit to 529 plan contributions. Secondly, you have the liberty of almost any investment with an ESA. This feature allows you to have more control and flexibility in achieving your goals.

The main features of an ESA are that the beneficiary must use their funds before age 30, or alternatively, transfer them to another family member for educational objectives to evade taxes and penalties. Unlike 529 plans, you can use an ESA for primary and secondary school expenses, not just college. Additionally, ESAs have income restrictions for contributors. They are not accessible to anyone earning more than $110,000 (single) or $220,000 (married filing jointly) annually. Also, nonqualified withdrawals from these accounts are taxed, and the beneficiary pays the tax.

To understand how 529 plans and ESAs are similar, you should know that both of them are investment vehicles. They allow your money to grow, and you benefit from compound growth so that you outpace inflation. ESAs provide more flexibility and options in the types of investments you can make, but both allow you to make the most of your money. For instance, if you put $2,000 into an ESA account every year up until little Suzie's graduation, which comes to a total of $36,000, and you earn an average compound interest of 8% over those 18 years, you would have a whopping ,893 at the end!

Choosing Between ESAs and 529 Plans for College Savings

2. Tax Benefits for Both

Saving for your child’s education is a wise decision, but select the right option to maximize your money. ESAs and 529s both offer tax benefits, similar to a Roth IRA – the money is taxed before it's deposited, and grows tax-free, without being taxed upon withdrawal if the funds are used for eligible education expenses. However, if you use the funds for other purposes, you’ll face a 10% penalty and federal taxes, regardless of the program you choose.

3. Transferring to Siblings

Naming a beneficiary is mandatory when opening a 529 or an ESA account. If your child receives a full scholarship, you can transfer the funds to a sibling or other relative of the initial beneficiary without paying taxes on the money.

Choosing the Right Plan for You

Deciding on the ideal plan for your family involves assessing several factors, such as your income, family situation, and anticipated career path your child will take.

An image of a chart comparing the ESA vs. the 529 plan.

To clarify your options, we’ll summarize the key differences between ESAs and 529s.

Maximizing Your College Savings with Professional Advice

Investment options are complex, and it's best not to invest in something you don't understand. Seek investment counsel from a professional to know your choices and receive clarity and confidence in selecting the best plan.

Get help from up to five investment experts in your locality through SmartVestor, a complimentary service that provides guidance.

Note that your specific situation may differ and to answer any questions you may have, engage a SmartVestor professional. Ramsey Solutions promotes participating pros but is not a paid client.

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