Coverdell ESA vs. 529: Which Education Savings Plan Is Better?

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Both Coverdell ESAs and 529 plans offer significant benefits for educational savings, including tax advantages and the ability to cover a wide range of educational costs. 

However, there are key differences between them that can help you decide which plan is right for you and maximize the value of your savings.Here’s what you need to know:

What Is a Coverdell ESA?

A Coverdell Education Savings Account, or ESA, allows someone to open an account for the benefit of a person under 18.  A person can have multiple Coverdell ESA accounts, but they can’t receive more than $2,000 in contributions a year without triggering tax penalties. They also can’t receive any more contributions after they turn 18.

You also can’t contribute to a Coverdell ESA if your adjusted gross income is above a specific level:

What Is a 529 Plan?

A 529 plan is another type of custodial plan that someone can open for another person. There are no age restrictions for the beneficiaries or income restrictions for the contributor.

However, 529 plans have more limitations on qualified expenses.

Coverdell ESA vs. 529 Plan: Tax Benefits

Both of these accounts allow contributions to grow tax-free — unlike investment products subject to capital gains tax. Contributions to both accounts are also not tax-deductible or tax-free for federal taxes. 

Withdrawals for qualified educational expenses are also tax free. If you use the funds to make a non-qualified withdrawal, you will have to pay income tax and a penalty. 

Qualified Expenses Comparison

Although both accounts are meant to be used for educational expenses, they have slightly different qualified expenses. 

How These Plans Affect Financial Aid

Both accounts are considered an asset of the owner (instead of the student). They are not taken into consideration when determining financial aid. Withdrawals are also not considered income for the student when being considered for financial aid. 

However, scholarships and grants are considered part of the adjusted qualified educational expenses. These expenses can affect how much of your account you can withdraw per year.

Investment Options and Control

Coverdell ESAs give the account owner more choices for how to invest the money than 529 plans do. 

Both plans also allow the owner to change the beneficiary. 529 plans allow the wonder to make guidelines for the types of withdrawals the beneficiary makes. Coverdell ESAs have different policies based on the institution that hosts the account.

Which Plan Offers Better Flexibility?

Generally, 529 plans have more flexibility. They have less limitations on the income of the contributor and the amount of contributions the account can have in a year. 

Even though Coverdell ESAs have more flexibility with qualified expenses, the contribution expenses can really limit how they’re used.

State Tax Benefits and Incentives

Coverdell ESAs have no state tax benefits. Although there are no federal tax benefits for 529 plan owners, some states allow tax benefits. 

For example: 

• Alabama offers a $5,000 tax deduction for contributions
• Colorado offers a deduction for the entire contribution
• Indiana offers a 20% tax credit on contributions up to $5,000

Early Withdrawal Rules and Penalties

If you withdraw from a 529 plan or a Coverdell ESA without a qualified expense, you will have to pay a 10% federal penalty and income tax on the money. Some states also charge a penalty tax on top of that. 

For Coverdell ESAs, if the account goes over the $2,000 annual contribution limit, the beneficiary will have to pay a 6% tax on every dollar that goes over that amount.

Which Plan Is Right for You?

Coverdell ESAs and 529 plans are both great tools to pay for education expenses. One beneficiary can even have both. If you’re looking to open an account, consider:

• Your income. If you’re over the adjusted gross income limit for a Coverdell ESA, choose a 529 plan.
• How much you want to contribute. If you’d like to contribute more than $2,000 a year, choose a 529 plan. 
• If you live in a state that offers tax benefits for 529 plans. Coverdell ESAs don’t get state tax benefits at all. 
• The education expenses of your beneficiary. Each plan has different qualified expenses. Coverdell ESAs have less limitations for K-12 education expenses. 529 plans are generally better for college students.

How To Open an ESA or 529 Plan

You can follow these steps to open your new account:

1. Research and compare plans: Use online resources to compare different Coverdell ESA and 529 plan options, focusing on fees, investment choices and state benefits.
2. Choose a financial institution: Select a bank, brokerage or mutual fund company that offers the plan you’ve chosen.
3. Complete the application: Fill out the necessary application forms, providing information about the account owner, beneficiary and your investment selections.
4. Fund the account: Make your initial contribution by transferring funds from your bank account.
5. Monitor and adjust: Regularly review your account’s performance and make adjustments to your investment strategy as needed.

Allison Hache contributed to the reporting of this article.

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