Education Savings Plan Frequently Asked Questions (FAQs)

What is the difference between a Coverdell ESA and a 529 Plan?

Both plans have tax benefits and help you pay for college. A 529 Plan is a great way to save because there are no contributor income restrictions or withdrawal deadlines. Also, the contribution maximum can range from $250,000–$300,000 for most plans. Coverdell ESAs are good for saving because they often offer a wider variety of investment options, and some elementary and secondary school expenses are qualified expenses.

What's the difference between a 529 Savings Plan and a 529 Prepaid Tuition Plan?

A 529 Savings Plan allows students to use savings at qualified colleges across the country. In contrast, a 529 Prepaid Tuition Plan is best suited for a student who is likely to attend a public, in-state college. Since your choice of colleges is limited to public, in-state colleges with a 529 Prepaid Tuition Plan, this may not be a good option for students who aren't certain about the college they want to attend. If a student with a 529 Prepaid Tuition Plan decides to attend a private or out-of-state college, he or she will have to forfeit a portion of the total value of the plan.

A huge benefit of the Prepaid Tuition Plan is that you lock in tuition rates, allowing you to pay "today's" tuition when it comes time to use the money for college. That could mean big savings, especially given how much college costs are rising. In contrast, with 529 Savings Plans, your contributions are invested in mutual funds and stocks, and you assume the risk of market conditions. The interest from your invested savings accumulates tax-free, and the money you save can ultimately be used to pay for your tuition, room and board, books and supplies, and mandatory fees.

Should I open a 529 Plan or a regular investment account to save money for education purposes?

In both cases, you are investing in stocks, bonds, or mutual funds, which carry inherent risks. But there are additional features of each alternative that you should consider.

With a 529 Plan, your investments grow tax-free, and you (or your parents) do not pay tax on withdrawals used for qualified education expenses. In contrast, if you invest in a standard investment account, your earnings do not grow tax-free, but you can always access the money to pay for any expense. Think of it like this: You could save for retirement by opening an account at your local bank, or you could open a Roth IRA to invest in mutual funds or stocks. The difference is that with the Roth IRA, you will also receive tax benefits. The same concept applies to 529 Plans: You will receive tax benefits by saving for college with a 529 Plan, just like you do with your Roth IRA, but your access to the funds is limited.

Additionally, withdrawals from a 529 Plan do not count as income on your federal student aid application (FAFSA), while capital gains withdrawals from mutual funds or stocks do count as income and can decrease your financial aid eligibility.

There are some instances when it is better to invest in mutual funds or stocks rather than a 529 Plan. One instance is if you think you may need to withdraw the money for an emergency or non-qualified education expense. If your money is invested in a 529 Plan, you will have to pay a 10% penalty on any non-qualified withdrawals. If your money is invested in a standard investment account, you will not have to pay a penalty.

What happens if a parent opens a 529 Plan but the student decides not to go to college or does not need all of the money that was invested?

If the student (beneficiary) does not go to college or does not need all of the money invested, the account can be rolled over to the account holder or a member of the beneficiary's family to pay for qualified college expenses. If the funds are withdrawn for non-qualified expenses, the withdrawals will be subject to taxes and a 10% penalty.

What is the difference between direct-sold and broker-sold 529 Plans?

State governments provide direct-sold 529 plans; qualified financial institutions administer broker-sold 529 Plans. Direct-sold 529 Plans have lower fees and, depending on the plan, may provide you with state income tax deductions not available with broker-sold plans. Broker-sold plans usually charge higher management fees because they often offer the guidance of an investment professional.

Can a beneficiary have more than one Coverdell account?

Yes, but the total of contributions from all accounts must be less than $2,000. Keep in mind that opening multiple Coverdell accounts will cause you to incur additional account management fees, which may offset the tax benefits your receive.

What happens if I open a Coverdell account but the beneficiary decides not to go college or does not need all of the money that I invested?

If the beneficiary decides not to go to college or doesn't need all of the funds, a Coverdell account may be transferred to another member of the beneficiary's family. The beneficiary may also withdraw the funds for another purpose, but keep in mind that withdrawals for non-qualified expenses are subject to taxes and a 10% penalty. Unlike with 529 Plans, the account holder cannot claim the funds for him- or herself.

Since more than $2,000 was contributed to my Coverdell ESA last year, what can I do so that I am not penalized?

You have until May 31 each year to request a refund so that you do not incur any penalties.

Once I've decided to open a Coverdell ESA, what do I do next?

First, make sure that the student is younger than 18 years old and that the contributor's income is within range to qualify. In order to contribute the maximum of $2,000 per year, contributors must earn less than $95,000 if filing singly or $190,000 if filing jointly. The maximum contribution is gradually lowered for contributors with earnings of up to $110,000 if filing singly or $220,000 if filing jointly. You may open a Coverdell account at a bank, mutual fund company, or other investment company.