One of the most important gifts you can give any child is the financial ability to achieve a higher education. Many parents establish college savings plans when their children are young to take advantage of the benefits saving early presents. But, when comparing 529 plans to education savings accounts (ESAs), which college savings plan is the best?
You want the best for your child, as well as the benefits you deserve. After all, the interest on college loans is atrocious, and the goal is to facilitate a solid foundation that sets a child up to reach their future potential—not saddle them with unnecessary debt. That can happen even if you have a college plan if you don’t understand what your plan offers and the terms. Also, if you don’t have a clear definition of what “qualified educational expenses” are, you’ll find those carefully saved college funds won’t cover some things.
It can be confusing, but we’ve done most of the homework for you.
Which College Savings Plan the Best? The Differences between 529 Plans and ESAs:
While there are similarities, the state-run 529 plans and education savings accounts each offer unique benefits you need to know before you decide on a plan. Although you can roll an ESA into a 529, you cannot roll a 529 into an ESA if you become dissatisfied. So, it’s crucial to perform your due diligence and compare the pros-and-cons of each to determine which college savings plan is best for your situation.
What expenses does each plan cover?
529 plans cover qualified expenses as defined by the IRS such as tuition, books, fees, supplies, computers, room and board at eligible colleges and higher learning facilities. Up to $10k of 529 funds can be applied to tuition only for kindergarten through twelfth grade at private, public and religious schools.
ESA funds can be applied towards qualified expenses during elementary through high school, as well as for higher education. Qualified expenses here include supplies (such as uniforms), tuition, books, fees, computers, and/or special needs. ESAs can also pay room and board for part-time students.
What are the contribution limits?
The limits for 529s depend on the plan and are a lot higher than ESA contribution limits. But, contributions to a 529 cannot exceed the cost of qualified expenses for the beneficiary’s education.
ESA annual limits cap out at $2k, but have the potential to earn greater, tax-free income inside the plan.
Anyone (parents, grandparents, aunts, etc.) can deposit money into to either plan. However, the total made by all cannot exceed the yearly limits of the plan.
How do the plans earn income on investments?
The 529 plan investments are allocated and limited by the plan custodian. The plan owner has no control over how the plan is invested.
ESAs, on the other hand, can use a wide spectrum of assets, such as mutual funds, stocks and money market funds—chosen by the account owner. Self-directed ESAs can also use private lending transactions and other options to grow tax-free income in the account. This is a critical difference because even though you can contribute more to a 529, ESAs have the potential to earn more income on fruitful investments.
How do self-directed education savings accounts work?
Self-directed ESAs work just as any other plan in the self-directed class: the plan owner has the freedom to invest in assets they know and understand. The choices are many, too, because the only thing the IRS doesn’t allow in self-directed plans are life insurance contracts and collectibles. However, because contribution limits max out at $2000 per year, you’ll have to choose assets the plan can afford. Make sure you choose the investments as wisely as you choose which college savings plan is best for you.
Understanding the Rules of Self-Directed ESAs
Choosing your own investments sounds fun and easy, but there are rules, regulations and other things you need to understand when you decide to self-direct any plan.
- You must be aware of prohibited transactions governing self-directed accounts. And, you should educate yourself on disqualified persons with whom your ESA may not purchase assets from or sell assets to. These are clearly covered in IRC Section 4975.
- Understand IRS rules that apply to education savings accounts themselves (which are in place whether you self-direct or not).
- You must designate a beneficiary under the age of 18 when you establish the account (unless you’re establishing it for a special-needs beneficiary).
- You must establish the account with cash contributions, which are not tax-deductible. However, the income grows tax-free provided the ESA’s earnings are less than the plan owner’s annual adjusted, qualified expenses for education.
- You are not required to make yearly contributions.
- Funds must be used for qualified educational expenses before the beneficiary turns 30 years of age.
Are you still trying to decide which college savings plan is best for you? This chart provides a handy, side-by-side comparison of how each plan works.
Midland deals with a multitude of clients who use self-directed education savings accounts. Please give us a call if you have any questions. We are here, and we are happy to help.
References (including some not used in the article):