College Savings Accounts: 529 Plans and ESAs

There are two types of tax-advantaged college savings plans designed to help parents finance education: 529 Plans and Education Savings Accounts (also known as ESAs or Coverdell accounts).

Both types of accounts offer tax-deferred growth. As long as the proceeds are used to finance qualified education expenses (like tuition, books, supplies, computers, and room and board), the money—including any gains and investment income—can be withdrawn tax-free. And unlike custodial accounts, both plans are considered to be your assets, not your child's, which means their impact on financial aid is significantly reduced.

But there are some important differences in terms of eligibility and the amounts you can contribute.

529 Plans

A 529 plan is a state-sponsored, tax-advantaged way to invest significant assets toward the cost of education. Each state offers at least one 529 plan, and each plan has a program manager. Plans vary by state and differ on costs, program features and investment selection. You do not have to live in a state to participate in that state's 529 plan. However, you should check to see if your home state offers a plan that provides its taxpayers with state tax and other benefits only available if you invest in the home state plan.

Important facts about 529 plans:

• Anyone can open a 529 account.
   
• Friends and family can contribute to the account regardless of who opened it.
   
• There are no income limits for opening and funding a 529 account.
   
• Withdrawals from a 529 account can be used to pay for qualified educational expenses at any eligible U.S. postsecondary institution or apprenticeship program. Withdrawals (up to $10,000) can also be used for K-12 tuition expenses. Up to $10,000 can be used to repay student loans for the account beneficiary, plus another $10,000 for repayment of student loans for each of the beneficiary's siblings.
   
• A 529 plan account has higher contribution limits than other types of education savings accounts.
   
• Similar to 401(k)s, investment options vary by 529 plan. Each state that offers a 529 plan determines how its plan is structured and which investment options are offered.
   
• Lifetime contributions can total $400,000 or more (the amounts vary by state) per beneficiary.
   
• If you have the resources, you can jump-start your children's college funds by depositing up to $75,000 in a single year (a couple can invest up to $150,000) without incurring a gift tax, as long as you make a special election and the contribution is your only gift to that beneficiary for five years (the IRS views the gift as $15,000, or $30,000 for a couple, over five years).

Education Savings Accounts

ESAs, also known as Coverdell accounts, are another tax-advantaged education savings option. Withdrawals can be used for qualified elementary and secondary education expenses as well as for postsecondary school. There are, however, qualifications and restrictions to consider before opening an ESA.

Important facts about ESAs:

• Only couples with adjusted gross incomes of less than $220,000 are eligible to open ESAs (for individuals, that figure is $110,000).
   
• Contributions are limited to a maximum of $2,000 per year until the beneficiary's 18th birthday.
   
• The account must be liquidated at age 30; however, the designated beneficiary may roll over the full balance to a different Coverdell ESA for another family member, thus avoiding the taxes and penalty.
   
• ESAs provide a wider range of investment options than 529s.
   
• Unlike 529s, ESAs don't have the $10,000 tax-free withdrawal cap for qualified expenses to an elementary or secondary public, private or religious school.