With rising costs of higher education, many parents and other relatives are looking for ways to save for future college expenses for children.  The sooner you start saving the more time those investments have to grow. Below, we outline the types of educational savings accounts and some frequently asked questions.

There are 2 types of educational savings programs:

Coverdell Educational Savings Account (ESA) which is similar to an IRA or Roth IRA where the contribution is limited to $2,000 per year, your modified adjusted gross income (MAGI) will reduce your contribution allowed when your MAGI is between $190k-$220k (Married Filing Joint), but you can invest in any stock or mutual funds or other investments available through a brokerage firm.  You can open an ESA with any brokerage firm. 

529 Plan or Qualified Tuition Program (QTP) is a state sponsored savings account.  You are not restricted to the state of residence and can choose between any state’s 529 plan.  These accounts act like a 401k plan where the state custodian provides a limited number of investment options (typically mutual funds).  A 529 plan has a high lifetime contribution limit per account which varies by state, however your annual contributions may be subject to gift taxes if you contribute more than the annual gifting limit (see below).  The maximum contribution for the State of California plan as of 2024 is currently $529,000.

Is there a tax benefit?

While there is no federal tax deduction for the contributions, the earnings inside the account grow tax free (like a retirement account) and when the future withdrawals are used for qualified education expenses, the full withdrawal is not taxable.  Which means that there is no tax on the growth of those investments when used for qualified expenses.

Over 30 states offer a state income tax deduction or credit for contributions made to the home state’s plan. There are nine states (Arizona, Arkansas, Kansas, Maine, Minnesota, Missouri, Montana, Ohio, and Pennsylvania) that do provide a state tax credit for contributions to any 529 plan.  Four states, California, Hawaii, Kentucky, and North Carolina do not have a deduction for any 529 plan contributions.

What are qualified expenses?

Qualified education expenses such as tuition, books, supplies, uniforms, room and board, computer equipment, and internet service.  This is not only for college but can be used for elementary and secondary (middle and high school) regardless of whether the school is private or public, religious, or secular.  However, there is a limit for 529 plans:

ESA – kindergarten through college

529 – qualified expenses for college and up to $10,000 for primary or secondary school tuition

Certain states do not adhere to federal tax laws on elementary or secondary education expenses, so you may owe state taxes on the withdrawals if you live in the following states: California, Colorado, Hawaii, Illinois, Michigan, Minnesota, Montana, Nebraska, New York, Oregon, or Vermont.

Can you use the funds for things other than college?

529 plans have a $10,000 tax-free withdrawal cap for qualified educational expenses for elementary or secondary schools including public, private, or religious schools.

Under the SECURE Act (Dec 2019) distributions from a 529 plan can now be used for apprenticeships, private K-12 tuition, and repayment of up to $10,000 of student loans for the beneficiary and their siblings.  There are state restrictions on using the 529 plan to pay student loans which could make the withdrawal taxable at the state level.  Check with your state to see if a loan repayment qualifies.

Do I have to choose one type of account?

No, your child can be the beneficiary of both an ESA and a 529 plan and you can contribute to both accounts in the same year.  However, you still need to be mindful of gifting limits.

What if the beneficiary doesn’t go to college or has a full scholarship and does not need the funds?

ESA accounts and 529 Plans can be transferred to another member of the family.  The IRS has a broad definition of “family member” which could include spouses, siblings, parents, stepsiblings, first cousins and in-laws.  Or the funds can always be withdrawn and used for non-qualified expenses, but there will be tax due on the earnings in the account and a 10% federal penalty, but no tax or penalty on the original contribution amounts.

The 529 plans can also use up to $10,000 to pay student loans of the beneficiary or a sibling.

An ESA account must be distributed when the beneficiary reaches age 30 unless they are a special needs beneficiary.  However, there is no age limit for a 529 Plan.

Additionally, under the SECURE 2.0 Act of 2022 in Internal Revenue Code Section 126, starting in 2024, you can transfer unused 529 plan funds to a Roth IRA for the beneficiary of the 529.  There are requirements and limitations to these transfers: the annual transfer is limited to the annual Roth IRA contribution limits ($7,000 in 2024), a lifetime maximum of $35,000, and the 529 plan must have been in existence for at least 15 years.

How much can I contribute to a 529 plan at one time?

Since contributions are subject to gift taxes most people will choose to stay below gifting limits ($18,000 per person in 2024).  However, there is an election to Super Fund a 529 plan where you can contribute 5 years of gifts in one year (for 2024 that would be $90,000 per person) and elect for the gift to be considered as gifted ratably over 5 years on a gift tax return.  This allows earnings to compound faster rather than making annual contributions.  Also, each spouse of a MFJ couple can make separate gifts to their child’s account ($180k total for 2024).  Additionally, each state has an aggregate limit that ranges from $235k-$542k.

Do I have to use the 529 plan for my state? Which 529 Plan should I choose?

This is a great question to review with your financial advisor to consider things like the age of kids, when the money will be used, who is contributing, contribution amounts etc.  You can also review the state rankings from an analyst like MorningStar and compare other state’s investment options and fees.  The state that sponsors the plan has no bearing on where the student can go to school; you can use 529 funds from any plan to attend any qualified educational program.

Will an educational benefit account affect financial aid?

Both ESAs and 529 Plans are generally given favorable treatment when calculating financial aid.  If a 529 plan is held in a parent’s name, typically only 5.64% if the assets are considered “available for college expenses” when calculating aid.  Some schools may use slightly different calculations and accounts held in grandparents or non-relatives’ names may or may not have to be reported.

If you have questions about educational savings programs and what you would qualify for, please reach out to a member of our team.



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