529 vs. Other Educational Savings Programs

Lamar Watson, CFP®

For many people, helping to pay for their children’s or grandchildren’s education is one of their main financial goals. It’s admirable to want to put your wealth toward bettering the next generation. 

What education savings programs are right for you? A 529 plan is one of the most common educational investment options, but there are other choices. Let’s explore the different programs to help you determine which one is right for you.

What Issues Should I Consider To Fund My Child’s College Education?

This checklist covers 20 of the most important planning issues to identify and consider when trying to determine how to fund your child’s college education. It’s structured as follows:

  • Financial Aid Issues
  • Funding Issues
  • Qualified Account Issues
  • Tax Planning Issues

529 Plans

A 529 plan is an investment account that offers tax benefits when used to pay for qualified education expenses for a designated beneficiary. These educational expenses could include a variety of things, including tuition for college or K–12 education, apprenticeship programs, or student loan repayments.1

The main benefit of a 529 plan is that the contributions grow tax free, and if the money is used for eligible educational expenses, the withdrawals are also tax free. In addition to this, over 30 states also offer a tax deduction or credit for 529 plans. For example, in New York, contributions to a New York 529 plan of up to $5,000 per year by an individual and up to $10,000 per year by a married couple filing jointly are deductible when computing New York taxable income.2 

Is The Distribution From My 529 Plan Subject To Federal Income Tax?

Investing in a 529 plan can be an effective strategy to save for college.  There are, however, some overlooked nuances related to 529 account distributions. And oftentimes, those nuances are not addressed (or even discovered) until after the distribution has occurred and the client is left with an unexpected tax liability.

To make the decision easier, we have created the “Is The Distribution From My 529 Subject To Federal Income Tax?” flowchart.  It covers some of the most common issues to consider when planning to take a distribution from a 529 account and considers:

  • What kinds of expenses are qualified
  • The tax impact if the expense is nonqualified
  • Considerations if the beneficiary is disabled
  • The formula for calculating Adjusted Qualified Education Expense (AQEE)
  • The impact of claiming the American Opportunity Tax Credit and Lifetime Learning Tax Credit
  • The formula for calculating the tax associated with any distribution (if applicable)

Another benefit of 529 plans is that they don’t have any annual contribution limits (although depending on where you live, they may have a lifetime contribution limit). This means you can save as much as you want for your family’s education. However, you may have to pay a gift tax if you contribute more than $17,000 in 2023.3,4

Finally, the beneficiary for a 529 plan is transferable, which means that if your intended beneficiary doesn’t end up using the funds for education, you can transfer the account to another beneficiary in your family. This could include a spouse, in-laws, children, nieces, or nephews, first cousins, aunts, uncles, or in-laws.5

Educational Savings Account (ESA)

An education savings account, or ESA, is another educational savings program available to people who want to help contribute to their child’s education costs. There are a few main differences between an ESA and a 529 plan.

The first difference, and benefit, of using an ESA is that you have more flexibility in how your contributions are invested. You can choose almost any investment (stocks, bonds, mutual funds, etc.). In comparison, in a 529 plan, the assets are invested in mutual funds, ETFs, and other similar investments, and you don’t get a say in how they are invested. This means that when it comes to asset allocation, you have more control and flexibility with an ESA.

But while you might have more control over your investments, you also have less flexibility regarding contributions and withdrawals. One primary consideration is that you can only invest $2,000 per year per child in an ESA. In addition to this contribution limit, there are income level restrictions. You can only use an ESA if you make less than $110,000 as an individual or $220,000 as a married couple filing jointly.6,7

Finally, there are more restrictions when it comes to the beneficiary. A 529 plan has no restrictions on the beneficiary’s age. With an ESA, you can only open accounts for beneficiaries who are under 18 and can only make contributions until they’re 18. Also, all funds need to be withdrawn before the beneficiary turns 30.6

Similar to a 529 plan, your contributions grow tax free and can only be used for educational expenses. One difference is that ESAs include other K–12 expenses outside tuition, while 529 plans do not.

Contributing to your loved one’s education is beneficial for them and can be a smart strategy for saving on taxes for you. Whether you invest in a 529 plan, an ESA, or another option, saving for the future is always a good idea.

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  1. https://www.savingforcollege.com/intro-to-529s/what-is-a-529-plan
  2. https://www.savingforcollege.com/compare-529-plans/state-tax-deductions
  3. https://www.savingforcollege.com/intro-to-529s/name-the-top-7-benefits-of-529-plans
  4. https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes
  5. https://www.thebalancemoney.com/transferring-529-plans-to-another-beneficiary-4157853
  6. https://www.savingforcollege.com/article/coverdell-esa-versus-529-plan
  7. https://www.calcpa.org/public-resources/ask-a-cpa/education/saving-for-college/coverdell-education-savings-accounts

By Lamar Watson, CFP®

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