Coverdell vs 529: Which is The Best Way to Save For College?

August 25, 2021
investment strategy

A Coverdell ESA and a 529 Plan are both investment vehicles that can be used to save for a child’s college expenses.

Each has its own advantages and disadvantages. For most families, a 529 plan is the more flexible and useful option. However, you’ll need to evaluate both and choose the one that makes the most sense for your specific situation.

Thankfully, comparing a Coverdell vs 529 plan is fairly straightforward. This article will cover the distinct differences. 

You’ll learn how each of these plans works — including details like who owns the plan and how you can fund them. Plus, we’ll discuss a third option you should consider as well.

What is a 529 Plan?

A 529 plan is a tax-advantaged investment account that you can use to save for higher education.

529 plans have been around for over 20 years. About 30% of America’s total college savings are currently held in 529 accounts.

There are no income level or age restrictions on 529 plans — anyone can open and fund one, and you can open a 529 plan for your kids, grandkids, or any other children in your life.

Pros and cons of a 529 plan
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Gains on the money held in a 529 plan aren’t subject to federal income tax when money is withdrawn as long as it is used for a qualified expense.

Qualified expenses for a 529 plan include things like:

  • Tuition and related fees
  • Room and board
  • Books and school supplies
  • Computers and related equipment
  • Repayment of student loans

While you can use the money in a 529 plan for non-educational expenses, you will need to pay tax and a 10% penalty on any non-qualified withdrawals.

It’s important to note that there isn’t a single federal 529 plan — 529 plans vary from state to state, with each one having its own maximum contribution limits (as well as other state-based details).

What is a Coverdell ESA, and How Is It Different From a 529 Plan?

A Coverdell Education Savings Account (ESA) is another tool that you can use to enable the children in your life to save for college.

Both a 529 plan and an ESA provide you with a tax-free way to grow savings that will be used to pay for education costs later on. 

You can transfer either type of account to the siblings of the beneficiary. And neither one will impact your FAFSA eligibility any more than the other.

However, a Coverdell ESA has some key differences to keep in mind.

Income level restrictions

Depending on how much money you earn each year, you may not be eligible to open or use a Coverdell ESA for the child in your life.

Currently, your gross income as an individual cannot exceed $110,000 per year if you want to use a Coverdell ESA. If you’re married, your gross income as a couple cannot exceed $220,000.

In comparison, a 529 plan has no income level restrictions.

Contribution restrictions

You can only contribute a maximum of $2,000 per year to the Coverdell ESA of any one beneficiary. 

In contrast, a 529 plan allows the contributor to claim a gift-tax exemption of up to $15,000. 

You can also contribute more than $15,000 per year to a 529 plan, but you may need to pay tax on any additional amount.

529 plans also offer something called “superfunding,” which allows contributors to make up to five years worth of donations (up to $75,000) in a single year.

Education expenses that are covered

You can’t use a 529 plan to pay for elementary or secondary school expenses. A 529 plan is limited to only tuition for these kinds of institutions.

A Coverdell ESA can be used to pay for elementary or secondary school expenses in addition to tuition.

Investment flexibility

In a 529 plan, you’re limited to choosing from the investment plans and asset allocations that your state offers.

A Coverdell ESA gives you the ability to take more control and self-direct the investments in your account. This is beneficial if you’re someone that wants more control over your investment choices instead of selecting from a specific offering.

Age restrictions

A Coverdell ESA must be used or transferred to another family member by the time the beneficiary turns 30. Otherwise, they may face taxes and penalties.

A 529 plan has no such restrictions. You can use the money in a 529 plan to go to college at any age.

529 vs ESA comparison
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How Will a 529 Plan or Coverdell ESA Impact Financial Aid?

Both a 529 plan and a Coverdell ESA will have a slightly negative impact when applying for financial aid, but the impact is minimal.

A 529 plan or a Coverdell ESA are both considered parental assets when filling out the FAFSA (Free Application for Federal Student Aid). It doesn’t matter if the assets are in an account owned by a dependent student or a parent.

Table showing the impact of 529 plans on FAFSA
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An asset protection allowance means that the first $10,000 of parental assets isn’t counted when calculating your Expected Family Contribution (EFC). However, once you go beyond that allowance amount, it'll start to affect your EFC calculation. 

A higher EFC means that you’ll be entitled to less financial aid.

For either a Coverdell ESA or a 529 plan, up to 5.64% of the assets contained within them will be counted toward the EFC calculation.

If a 529 plan or Coverdell ESA is owned by a grandparent or any other relative besides a parent, nothing will need to be reported until the funds are withdrawn.

Coverdell vs 529: How The Plans Work

With a Coverdell ESA, your only option is to deposit money into the account while you’re saving for a child’s college education. The funds are then later withdrawn and used to pay for education expenses.

A 529 plan allows you to do the same thing. You can put money into the plan and then later withdraw it for education expenses. 

However, there's also a second option available with a 529 plan called a prepaid tuition plan. It allows you to lock in the current rate of tuition. That way, you won’t be subject to any increase in tuition prices as a result of inflation. 

Coverdell vs 529: Who Owns The Plan?

A Coverdell and 529 plan are technically owned by different people. Let’s take a look at the difference.

A 529 plan is set up in the name of the contributor

When you open a 529 plan, the account must be in your name. You don’t have to specify which child the account will be used for.

This is an advantage if you’re the account holder and you’re not sure if the child in your life will go to college. It gives you more control and flexibility to adjust and reallocate the funds to someone else if needed.

The top five benefits of 529 savings plan
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Having the funds in your own name means that you also have access if you need them for an emergency — although you’ll have to pay a penalty to use them for a non-education-related expense.

A Coverdell ESA must be in the name of the beneficiary

Ownership of a Coverdell ESA is the opposite of a 529 plan. The account must be in the name of a designated beneficiary and not the person contributing to it.

That means that once you contribute to the account, it’s out of your hands. If something changes, you can’t withdraw the funds yourself.

However, you can change the beneficiary to another child without facing tax penalties if the original beneficiary decides not to go to college. 

This transfer is restricted to only members of the beneficiary’s family, however. So you can’t transfer a Coverdell ESA from your daughter to the child of a friend.

How Do You Invest With a 529 Plan or Coverdell ESA? 

When it comes to investing in either a 529 plan or a Coverdell ESA, you first need a way to add funds to the account. Then you need to allocate the money to specific types of investments so it can grow over time.

Let's break it down.

How money gets added to the accounts

With either a 529 plan or a Coverdell ESA, the process of creating and adding funds to them is the same.

You can contribute money to either plan whenever you wish as the child in your life is growing up. 

Some family members may opt to contribute to a college savings plan rather than buying toys on special occasions, for example. They can do this by writing a check or making an electronic funds transfer.

More involved family members may choose to have a contribution to the 529 plan come directly off the pay they receive from their employment on a weekly or bi-weekly basis.

How the money is invested

With either type of plan, you’ll need to choose an asset allocation. An asset allocation determines the types of investments that are used to grow your college savings plan.

Generally, funds in either a 529 or ESA are invested more aggressively early on. The majority of the funds are typically invested into stocks when a child is young. This offers a higher expected rate of return over time but also more short-term volatility.

As the child in your life gets closer to entering college, the asset allocation changes to emphasize maintaining and preserving the wealth that already exists. 

Can You Convert a Coverdell ESA to a 529 Plan?

Coverdell ESAs are more restrictive than 529 plans in many ways.

They have higher fees and offer fewer tax breaks. There are fewer eligible expenses that you can spend the savings on. And there are also age limits to worry about.

The good news is that if you’ve already created a Coverdell ESA, it’s possible to roll it over into a 529 plan if you’ve decided that’s the better fit for you.

Moving money from an ESA to a 529 plan counts as a qualified education expense, so you won’t pay any penalties to make the move.

How to rollover a Coverdell ESA to a 529 plan

First, you’ll need to open a 529 plan to move your ESA funds over to. You can do this directly or use a financial advisor.

Then, you simply withdraw the funds from your Coverdell ESA and fund your 529 plan with the money.

In order to avoid penalties, you need to deposit the full amount into the 529 plan within 60 days of withdrawing it from the ESA.

Coverdell vs 529: Which is Right For You? 

In general, most people will benefit more from creating a 529 plan for the child in their life rather than a Coverdell ESA.

Creating a 529 plan offers more flexibility and is likely the best choice if you’re planning to use the account to save for college. This is especially true if you have multiple children that you’d like to use the money for and if you think you’ll contribute more than $2,000 per year.

A Coverdell ESA may be the better choice if you’re saving for private school or other specific situations where you want to cover primary or secondary education expenses.

An ESA may also meet all of your needs if you’re only saving for one child and you aren’t planning to contribute more than $2,000 per year.

A third option to consider: custodial accounts

Opening a custodial account, such as a UGMA (Uniform Gifts to Minors Act), may be an attractive alternative to either a 529 plan or Coverdell ESA for you to consider.

These accounts have no funding limits or expense restrictions. The child owns the funds from day one and can spend the money on whatever they like.

While custodial accounts don’t have the same tax benefits as a 529 plan or ESA, they can make an excellent alternative or addition.

They’re a great way to create general-purpose savings for the child in your life and start building wealth from day one. Unlike a 529 plan or an ESA, there are no tax penalties (or outright restrictions) if used for anything other than educational expenses.

In addition to your own children, they can be a great way to provide your grandchild, godchild, niece, or nephew with money to use however they’d like. They can use the money to buy their first car, go backpacking across Europe, or anything else.

For more on this, check out our guide on custodial accounts vs 529s.

Coverdell vs 529 vs Custodial Account: What’s Right For You?

529 plans and Coverdell ESAs both have their pros and cons when it comes to building college savings for the child in your life.

However, a Coverdell ESA tends to be the more restrictive and limited option of the two.

There's a lot more to save for besides college, though. EarlyBird is the simplest way to invest in the financial future of the children in your life. 

Download the app and see how you can launch an investment account in just a couple of quick minutes. Then you can invite your family and friends to send gifts as well.

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