No matter how old your children, you’ve probably considered—and worried about!—how you’ll pay for their college education. What you may not know is that many savings vehicles exist for just this purpose. In the United States, the most well-known programs focused solely on saving for education expenses include the Education Savings Account (ESA) and the 529 Plan, which is named after the relevant tax code section. Although you can use other methods to pay for tuition—like cash-value life insurance or your 401(k) plan—an ESA or 529 Plan may be able to give you the best bang for your buck without busting your wallet.
Education Savings Accounts (ESAs)
ESAs are frequently referred to as “education IRAs” or Coverdell Education Savings Accounts (after the senator who sponsored the law creating them). These accounts can be set up by a parent, relative, or friend for children under the age 18 who have Social Security Numbers. You can contribute up to $2,000 to these accounts on an annual basis, and while there are income limits on who can contribute, grandparents, godparents, aunts, uncles, or other adults can donate. You can even gift the money to your children and have them contribute to their ESA directly! As with all savings vehicles, there are other important features to consider:
- ESA funds grow tax-free and are not taxed when withdrawn. As long as the money is used for qualifying education expenses (e.g., tuition, fees, books, or laptops).
- ESA contributions are not tax-deductible.
- ESA funds aren’t just for college; they can also be used for elementary and secondary school education expenses.
- There are also broad investment options for ESA funds, often providing parents with a full array of mutual funds, bonds, and individual stocks.
A 529 Savings Plan is another tax-advantaged vehicle for saving for your child’s education. These plans were created by the federal government and are administered by each individual state. There are two types of 529 Plans: prepaid and savings. A prepaid plan lets you purchase tuition credits to be used in the future, and the performance of your funds depends on tuition inflation. A savings plan is funded solely by market growth and the performance of individual investments.
Once you enroll in these plans, whether by making a single or ongoing contribution, the Plan handles investments. In general, associated fees and limitations are minimal (though you should check on these with your Plan provider), and there are usually no limits on the amount of money that can be contributed to the account. These features makes the 529 Plan a potentially more “hands-off” approach to college savings. But because 529 Plans may vary on a state-by-state basis, there are some important aspects to keep in mind:
- While you can shop for 529 Plans in other states, you generally need to use one based in your home state to receive tax benefits (such as a state income tax deduction).
- The state 529 Plan you choose is not tied to the state where your child eventually attends college.
- Unlike an ESA, 529 Plan funds may only be used for college expenses (not for elementary or secondary school).
- Be sure you understand whether your 529 Plan is a prepaid plan or a savings plan. One may be a better fit for your family than another.
- Don’t forget that any non-qualified withdrawals from a 529 Plan (or from an ESA, for that matter) will be taxed!
Determining which savings plan is best for your family depends on multiple factors, including how much you want to save, tax benefits, income level, and whether you’d like to use funds for college or for K–12 education. For some families, using both a 529 Plan and an ESA makes the most financial sense and provides the greatest tax advantages while simultaneously meeting your savings goals.
Still have questions? Don’t hesitate to call a professional. Your local tax advisor will be able to provide you with information specific to your family’s needs.