Comparing Education Savings Plans: ESA and 529
Updated: Mar 27, 2020
Americans have two main choices when saving for college: a 529 plan or an Education Savings Account (ESA).
The first option, 529 plans, come in two varieties: 1) prepaid tuition and 2) savings plan. Prepaid tuition plans are less popular than they once were. Pegging tuition at a certain rate sounds like a great idea, however, it turns out that saving money and investing it works out more in the saver’s favor.
States run 529 plans. They’re funded with Federal after-tax dollars, meaning the gains and qualifying withdrawals are tax-free. Some states allow savers to take a state deduction for the contribution. Investors do not have to participate in the 529 plan from their state.
The three biggest benefits of 529 plans are the high contribution limits, lack of income limits, and lack of age limits for the student. Savers can contribute up to $15,000 per year and they can have high incomes with no limits. If the investor wishes, they may front load the plan for $75,000 if then make no contributions for the next four years. The contributions are permitted to get into the hundreds of thousands as well. Additionally, the beneficiary of the 529 account can be any age when they attend school, and school includes K-12 (since the Tax Cuts and Jobs Act). However, it’s important to note here that the investments would not have as much time to grow if used early in the beneficiary’s life.
The main downside of the 529 plans is that there are limited investment options. Investors must choose from a limited list, like those of 401(k)s.
Unlike 529 plans, ESAs can be opened at any broker, and thus have a wide range of investment options. They are not state run, meaning there is no state deduction at all. They have the same tax benefits at the Federal level, though, because ESAs are also funded with after-tax dollars.
The top reason investors pick ESAs over 529 plans is the investment flexibility. ESAs can also be used for K-12 expenses. However, unlike the 529 plans, this money must be used by the time the beneficiary reaches 30.
The reasons investors choose 529 plans over ESAs are the low contribution limit and the income limits. Only up to $2,000 per year can be contributed to an ESA. The income limit for making a maximum contribution is $190,000 for married couples filing joint tax returns, and contributions phase out completely at $220,000 in 2020. For single filers, the contribution limit is $110,000.
What if the beneficiary doesn’t use the money?
With either plan, 529 or ESA, the beneficiary can be changed without penalty so long as the new beneficiary is related to the prior beneficiary.
What is the right choice for me?
If you highly value investment choice, an ESA is probably the right pick. If you’d like to contribute more than $2,000 per year and/or if you have a high income, the 529 plan is the right option. There are also huge potential tax benefits depending on the ability to deduct contributions from state income tax filings, and that would lead to 529 plans being the optimal choice.
It's great to educate yourself as much as possible on personal finance matters. Remember to consult a financial adviser or planner though. You may have a good idea of which direction you’d like to go, and they will be able to confirm whether an ESA or a 529 plan in the best choice for your family.