Coverdell education savings accounts and 529 plans are both designed to help save for future educational expenses. Neither account offers a tax deduction for contributions, but the money grows tax-free in the account and the contributions and earnings come out tax-free as long as the money is used for qualified expenses. But, qualified expenses differ between ESAs and 529 plans.
To contribute to an ESA, your modified adjusted gross income must fall below the annual limits -- either $110,000 if you're single or $220,000 if you file a joint return as of 2012. In addition, beneficiaries must be under 18 years old unless they are special needs beneficiaries. Plus, once the beneficiary reaches 30, the account is deemed distributed, so you must pay taxes on the remaining money, if any. By contrast, there are no income limits for 529 plans and no age limits.
ESAs limit contributions to $2,000 per year, per beneficiary. For example, if you contribute $2,000 to your daughter's ESA, your parents can't also chip in $2,000 for your daughter. If you had three children, you could contribute $2,000 to each of their ESAs. On the other hand, 529 plans allow you to save as much as is reasonably necessary for the beneficiary's qualified expenses -- the specific limits are set by each state and are usually well into the six figures.
ESA only offer one option: you invest the money and then, when you need money, you take distributions to pay your educational expenses. On the other hand, 529 plans can either let you prepay college expenses or put the money in an account and save it. For example, a 529 plan might let you lock in today's tuition rates at a specific school by paying now instead of when the beneficiary eventually attends the school.
ESAs offer a wider range of investment options than 529 plans. With an ESA, you can choose any financial institution and invest in mutual funds or individual stocks and bonds, but not in a life insurance contract. If you have a 529 plan, you must choose from one of the state-approved investment options. In addition, you can only change the investment once per 12-month period. You can also change your selection if you change the beneficiary.
ESAs offer a more expansive definition of qualified expenses than 529 plans. Qualified distributions from 529 plans are limited to post-secondary costs like tuition, books and supplies for college, trade school or graduate studies. If the beneficiary is enrolled at least half-time, room and board also qualify. You can use ESA distributions for elementary school and high school expenses as well as college costs.
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