Coverdell Education Savings Account (ESA) vs. 529 Plan: Which Is Right for You?

The Coverdell ESA was designed for families saving for education, but over time many of the benefits they offered have been eclipsed by the benefits of 529 plans. 529 savings plans are more flexible, and in light of legislative changes over the past few years, and allow families to pay for a wide range of educational costs including K-12 expenses.

If you want to save for any type of education from kindergarten to graduate school as well as vocational programs and continuing education, it’s difficult to do better than a 529 plan. Consider the best 529 plans available today. 

What Is a Coverdell Education Savings Account?

Coverdell ESAs generally offer greater investment flexibility than 529 plans, and tax-free withdrawals for college expenses as well as a wide range of elementary and secondary school costs (K-12). If your child is young enough–not yet 18 years old–and your income is low enough (the income phase-out is $95,000 to $110,000 for a single taxpayer and $190,000 to $220,000 for a married couple filing jointly), you can contribute up to $2,000 per year to a Coverdell ESA for that child.

Unlike 529s, ESA assets are not revocable. The account must be established for the sole benefit of the child. In fact, an ESA has a custodian–and it’s not you. The ESA custodian is the bank or other financial institution you use to open the account, much like the way you open an IRA.

As the ‘responsible individual’, you get to call the shots on investments and distributions, but distributions from an ESA is always paid to the beneficiary and cannot come back to you. Unspent funds remaining in the account when your child reaches age 30 must be distributed at that time, subject to tax and a 10% penalty on the account growth if he or she does not have qualified education expenses in that year. Federal tax law says the beneficiary can be changed to another family member below age 30 without triggering tax or penalty.

What Is a 529 Plan?

A 529 savings plan, officially known as a “qualified tuition program” are state-sponsored savings plans that provide a number of tax benefits. There are two main types of 529 plans: Section 529 prepaid programs and Section 529 savings programs. The latter is much more common, as currently, only a handful of states offer prepaid programs.

529 savings programs work in a similar way to a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds and similar investments. You get a choice of investment portfolios, though you’re limited to the options offered by your 529 plan. Contributions are invested in stocks and bonds and when you need to withdraw money to pay for your child’s education, you just need to direct the program administrator to distribute the required funds to you or your beneficiary.

529 savings plans are highly flexible, allowing you to change the beneficiary at any time. This means that you can change the beneficiary to a sibling if your child decides not to go to college. The plans are professionally managed by experienced investment managers and offer generous contribution limits.

Coverdell Education Savings Accounts vs. 529 Plans

Though both Coverdell and 529 plans can be used to save for college, there are a number of key differences between the two. 529 plans have much more generous contribution limits and offer a greater degree of flexibility, except when it comes to investment options. Coverdell ESAs offer much greater control and flexibility when it comes to investments, but are much more restrictive when it comes to contribution limits, income level restrictions, and age restrictions.

This Coverdell vs 529 comparison chart gives you an overview of the key differences between Coverdell education savings accounts vs 529 plans:

When to Choose a 529 Plan

Overall, a 529 plan is the best choice for most families. These plans have few limitations, offer tax benefits, and are designed to help families pay for college, as well as elementary and secondary school tuition. Depending on your income, the age of the beneficiary, and their study plans, a Coverdell ESA may not be an option at all, given the stricter limitations of these types of plans.

A 529 plan is best for families who:

• Earn more than $190,000 a year, or $110,000 a year for single tax filers
• Want to be able to contribute more than $2,000 a year
• Have a child who is over 18, or want to be able to make contributions after they turn 18
• Have a child who may want to return to study later, or do an advanced degree that means that they may still be in school when they’re 30
• Want the flexibility to pay for a wide range of education options, including K-12 expenses, college, graduate school, vocational schools and workforce training, apprenticeships, continuing education, and credentialing.

Another factor that may help you to decide whether to opt for a 529 or Coverdell is where you live. If you live in a state that offers great tax benefits for 529 contributions and disbursements, this makes a 529 plan even more advantageous.

In addition, leftover 529 funds can be rolled over to a Roth IRA for the beneficiary federal tax and penalty-free, when certain conditions are met.

When to Choose a Coverdell Education Savings Account

A Coverdell ESA could be a good choice for families who want to have the flexibility to choose their investments, but they will be subject to many limitation they wouldn’t be subject to with a 529:

• Must earn less than $190,000 a year, or $110,000 a year for single tax filers
• Have a child who is not yet 18
• Are certain their children will finish college by the age of 30
• Don’t want to contribute more than $2,000 per year

Also note, the Coverdell ESA does not work as well as 529 plans for grandparents and other relatives. Let’s say you drop $2,000 into an ESA for your child this year, and a grandparent opens another ESA with $1,000. The annual contribution limit has been breached and your child owes a 6% excise tax on the $1,000 excess.

Most, but not all, ESAs protect against this unfortunate result by requiring that a parent or legal guardian, and not the grandparent, be named as the responsible individual on any ESA set up for your child. So at least you as the parent will get a chance to notice the excess contribution and take it back out of the ESA before May 31 of the following year, thereby avoiding penalties.

If your circumstances change and you wish you’d opted for a 529 plan instead of a Coverdell ESA, it is possible to roll over your plan to a 529 as long as you keep the beneficiary the same. Check these posts to learn when you should consider a Coverdell ESA to 529 plan rollover and the benefits of doing so. Note also that you cannot go from a 529 plan to an ESA.

How Does a College Savings Account Impact Financial Aid?

College savings accounts can impact your eligibility for financial aid, though the impact is generally limited when calculating the SAI (Student Aid Index), which is used as a basis for issuing financial aid.

Both 529 and Coverdell ESAs are two of the better options to save for college without a severe impact on financial aid. Parent-owned 529 and Coverdell accounts are considered assets to determine the EFC, but only up to 5.64% of the value. Grandparent-owned accounts are not included. Student-owned 529 and Coverdell accounts do not need to be included with the student’s other investments.

Withdrawals from either type of account are treated favorably, regardless of the account owner starting with the 2024-2025 FAFSA award year. 

How to Open a 529 Plan

Almost every state offers at least one 529 plan, and sometimes more than one. However, you’re not limited to your home state’s 529 plan. Keep in mind that your account can increase or decrease over time depending on how your investments perform.

Therefore, it’s important to consider your investment options, do your research, and choose the best 529 plan for you accordingly.

The Bottom Line

Both 529 plans and Coverdell ESAs can be excellent options for families to save for college. 529 plans are more flexible, have fewer limitations, and are generally a solid option for any family. If you meet the criteria and will not be bothered by the age or contribution limitations, a Coverdell ESA can also be a great option that allows you more freedom to choose your investments. You can also roll your Coverdell over to a new 529 plan if you find that to be a better fit.

Frequently Asked Questions (FAQs)

Is Coverdell the same as a 529 plan?

No, a Coverdell is not the same as a 529 plan. While both are designed to help you save for college, each has different limitations and restrictions. A Coverdell savings account is only available to families under certain income and age limits for beneficiaries applying, and a 529 savings plan is more flexible in general but offers more limited options for investments.

What happens to Coverdell if the child doesn’t go to college?

If your child doesn’t go to college, they can withdraw the money from the account (in fact, any remaining funds will be automatically distributed to them if not used when they turn 30) and they will be taxed on the withdrawal. With a 529 plan you can change the beneficiary to another child.

Can you have both a Coverdell and a 529 plan?

Yes, you can absolutely have both a Coverdell and a 529 plan, as long as you meet the requirements for a Coverdell. In fact, it can be a good idea to invest in different types of plans to take advantage of the benefits of both and diversify your investments.