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Why Not Use An ESA Instead Of A 529 Plan

Aug 9, 2012

The two best ways to save for college in a tax efficient way is the Coverdell Education Savings Account (ESA) and the 529 College Savings Plan. You are may be wondering, does one plan have a better result than the other. The two plans have many differences and their use depends on your individual families situation.

Coverdell ESAs and 529 plans are different by who may invest in them. As of 2010, the Internal Revenue Service (IRS) restricts investments to a Coverdell ESA to individuals whose modified adjusted gross income is less than $110,000 for single filers or $220,000 for joint filers. The ESA beneficiary must be under the age of 18. With a 529 plan, there are no restrictions on income. Account owners of 529 plans may name anyone a beneficiary, including themselves, regardless of age.

There is a significant difference in the maximum amount you may contribute to an ESA versus a 529 plan. As of 2010, the IRS limits your annual ESA contribution to $2,000 per student until he reaches age 18. With a 529 plan, each state establishes its own lifetime contribution limits. According to Financial Aid Finder, maximum contribution limits for state 529 plans ranged from $100,000 to $365,000 in 2010. You are not required to be a resident of a particular state to contribute to that state's plan.

A qualified withdrawal is slightly different for ESAs and 529 plans. According to IRS Publication 970, funds in a Coverdell ESA may be used to pay for education expenses at an eligible elementary, secondary or post-secondary school. ESA funds may be used to pay for tuition, books, fees, room and board, tutoring, uniforms, transportation, computer equipment and special-needs services. Funds from 529 plans may only be used to pay for tuition, fees, books, and room and board at any post-secondary institution that is eligible to participate in federal student aid programs.

Education Savings Accounts and 529 plans differ in the investment options they offer. According to Financial Aid Finder, ESAs offer a wider range of investment options, including stocks, bonds and CDs as well as mutual funds. With a 529 plan, your investment choices are typically limited to a small number of mutual funds, which usually include age-based and target asset allocation options.

One of the primary things to consider when choosing between an ESA and a 529 is their potential tax implications. The IRS imposes a 10% tax penalty on distributions from either type of account that fails to meet the guidelines for a qualified withdrawal. In addition, the IRS requires you to withdraw all funds held in an ESA prior to the beneficiary reaching age 30 in order to avoid incurring an additional tax penalty.
Got further questions? Catch me on twitter and DM me @529SavingsPlans or e-mail me at 529CollegePlans at Gmail.comWant to be heard? Leave a reader comment below.

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