Parents who are building a college fund for their child or children have two tax-advantaged alternatives, the 529 plan and the Coverdell Education Savings Account (CESA).  Contributions to 529 plans and CESAs are not tax deductible, but there is no tax as the income builds up in the account. Distributions from the plans are tax free if they are used for qualified education expenses. The definition of what qualifies is not the same for the two approaches.

CESAs have one advantage over 529 plans. Where 529 plans are typically limited to just a few investment choices, with the money managed by the plan sponsor, there are no similar limitations for CESAs.

However, there are CESA disadvantages to consider also, where the 529 plan is superior. Most importantly, no more than $2,000 per year per student may be contributed to an ESA. Second, contributions must end when the beneficiary reaches age 18. Therefore, no more than $36,000 total may be set aside for one student, which almost certainly will fall far short of the financial need. Still, having a dedicated capital source that is growing tax free as one begins higher education is nothing to sneeze at.

A third problem is that contributions to CESAs are not permitted for those whose income is too high—modified adjusted gross income of $110,000 for singles, $220,000 for a married couple. No similar limitation applies to the 529 plan.

Successor beneficiaries

What if the beneficiary decides against college? The CESA accumulation may be rolled into another CESA for a family member of a beneficiary, or a new beneficiary may be designated for the 529 plan. The new beneficiary must be of the same or higher generation as the original beneficiary.  Alternatively, subject to a variety of rules, unused 529 plan money may be rolled into a Roth IRA for the beneficiary.

The CESA must be distributed by the time the beneficiary reaches age 30, or within 30 days after that date. The distribution may be in the form of a rollover to another family member. Amounts not rolled over and not used for qualified expenses are included in taxable income, and a 10% tax penalty applies. No such age limits apply to the 529 plan.

Start early

As valuable as the tax advantages of CESAs and 529 plans may be, the biggest advantage is starting early. The sooner one begins setting aside funds for a college education, the more time that capital has to grow into something significant.

(February 2025)
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