Coverdell Education IRA and 529 Explained?

Categories: College, D Ramsey

Following Dave Ramsey’s “From Fruition to Tuition” class, people often ask me about the education savings accounts and 529 plans.  It seems there is a little confusion.  Briefly…

The Education Savings Account (ESA) and the Coverdell Education IRA are one and the same. They are accounts that are set up specifically to fund college education. They are not tax-deductible for Federal income tax purposes, but they grow tax deferred, meaning that if they are used for college education, then the growth is not taxed when used for that purpose. A few states allow the tax deduction from state income  taxes. The contribution limit is $2,000 per year per beneficiary, but  it depends on the Adjusted Gross Income. The money can be invested in a wide range of investment accounts. This is the main reason Dave Ramsey recommends them over 529 plans.

The 529 plans are similar in many ways to the ESA. The biggest exception is much higher contribution limits. This is a little too complex to explain here, but per the website: “Contributions can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary.” The 529 plans available vary by state. In Ohio, where I live, the investment choices are limited to five investment or bank firms. Individuals may purchase a plan offered in another state, if they prefer; however, some states offer advantages to purchase in your home state. There is a second type of 529 plan: purchasing pre-paid tuition credit. Your investment return is essentially tied to the rate of increase of qualifying school’s tuition and room and board. One investment professional I spoke to recently told me that since people can contribute more money to 529 plans versus ESAs, states are expanding their investment choices or are buying one out-of-state 529, and 529 plans are more flexible long-term (if the original student doesn’t use the funds) that fewer people are using ESAs today.

Investors should discuss the options with their tax advisors, investment professionals/financial planners, and they should spend a lot of time reading all of the information on their state’s 529 website before making a decision. You will want to know how these accounts affect qualifying for financial aid, fees, and limitations.