What is the Difference Between an ESA and a 529 Plan?

This is a question I received and I thought it was worth writing about. 

An ESA is an Educational Savings Account.  It is also called a Coverdell ESA. 

A 529 Plan or a 529 College Savings Plan is a special kind of state government account or investment plan that is to be used for education.

Both the 529 and the ESA are special savings accounts / investment plans that can be used for funding education.  They both use after tax money and allow the money to grow tax free.  Withdrawals from these accounts are not taxed if the money is used for qualified expenses.  Qualified expenses generally include tuition, room and board, and education supplies such as books or a computer, etc.

If for some reason you do not need to use all the money in one of these accounts (your child got a scholarship) you can change the beneficiary to any family member in the beneficiary’s generation or above.  For example, you could give the extra money in the account to the original beneficiary’s sibling or cousin or even an aunt or uncle or grandparent (going up a generation) but you cannot save it and give it to the named beneficiary’s child.

The ESA allows you to invest the money ANY way you want to.  For an ESA you can open this type of account at a brokerage firm of your choice, like TD Ameritrade or Charles Schwab and then you can select any investment vehicles you want.  You can choose individual stocks, bonds, mutual funds, etc. 

You can move the ESA account to different brokerage firms whenever you want and as many times as you want.  There is no limitation on that.

The 529 Plans are specific plans that most states offer.  There are many 529 plans to choose from.  You can only invest in the investment options allowed within that 529 Plan, kind of like a 401k where you can only chose from the specific 401k options.  Most 529 plans have static mutual fund or exchange traded fund (ETF) choices and age based portfolios that change the asset allocation depending on the beneficiary’s age.

Because the 529 Plans are state run plans, some of the plans qualify for state income tax benefits in addition to the federal income tax benefit on withdrawals.  Please note that you do not have to invest in your state’s 529 plan.  In order to get the state income tax savings, SOME of the states require that you invest in their plan but that is not true for all of the state.  The ESAs do not have this possible state income tax benefit.

The IRS will only allow you to move from one 529 account per beneficiary to another, one time each 12 month period or they view it as an unqualified withdrawal and you will be penalized with a 10% penalty in addition to the federal income tax due on the earnings in the account.

A big change with the 2018 income tax reform is that before 2018 only the ESA could be used for primary and secondary school (K-12) AND college expenses.  With the tax reform you are now allowed to spend up to $10,000 per year per beneficiary for primary and secondary school from a 529 plan.  Any dollar amount is still allowed for higher education – college or graduate school expenses from a 529 plan or ESA. 

Here is a table of some other important differences:

 
It is important to note that you can invest in both an ESA and a 529 plan but for simplicity’s sake and for the advantages of the 529 I would recommend that you just go with a 529 College Savings plan.  The earlier, the better, IF you have the cash flow and savings to do so. 

Remember to first plan and save for your own retirement before saving for your children’s’ college education.  Your child can get a loan for college.  You cannot get a loan for your retirement.