Education Savings Vehicle: Definition, Pros & Cons

Instructor: Noel Ransom

Noel has taught college Accounting and a host of other related topics and has a dual Master's Degree in Accounting/Finance. She is currently working on her Doctoral Degree.

This lesson includes an overview of the various types of education savings accounts as well as the features, advantages, and disadvantages of each option.

What Are Education Savings Accounts?

Kevin and Natalie just had a baby! The couple is super excited about the new addition to the family. After a few conversations with family members, Kevin and Natalie decide to do some planning for their son's future. Part of their plan includes saving for college. The couple realizes that the cost of college has grown quite a bit since the two of them were in school, and that trend will probably continue. But they really want college to be an option for their son, so they start to do some research and they enter the world of education savings accounts.

An education savings account is exactly what it sounds like--an account meant to help you save money for education. There are many different types of accounts, including qualified tuition programs or 529 plans, Coverdell Education Savings Accounts, custodial accounts, and savings bonds. As they research, Kevin and Natalie become confused about which plan is the best plan for them. Natalie suggests they write a list of benefits and disadvantages of each plan to help them make a decision.

Characteristics of Education Savings Accounts

529 Plans

Qualified tuition programs, more commonly known as 529 plans, come from Section 529 of the Internal Revenue Code. They are state-sponsored savings plans managed by states or educational institutions. You have to be at least 18 to open a 529 plan and anyone with a tax identification number or Social Security Number can be a beneficiary of a 529 plan. The beneficiary can also be the person who opens the 529 plan.

The assets in a 529 plan grow tax-free and the money withdrawn from the plan is tax-free as long as the beneficiary uses the funds for qualified education expenses, such as books, tuition, fees, and room and board. Contributions are generally not tax-deductible, and there are no income limitations for individuals who want to open the 529 plan. However, some states allow tax deductions for contributions if the owner of the plan is a resident of the state.

If the beneficiary withdraws money for something other than educational expenses, the amount taken out is subject to ordinary income tax and an additional 10% tax penalty. If the original beneficiary of the account gets a scholarship or does not go to college, there is an option to transfer the account to another beneficiary.

Kevin and Natalie are very excited about the features of the 529 plan. They discover they can also contribute a lump sum of up to $70,000 in a single year to the plan to accelerate their savings. A contribution of $14,000 a year is also allowed if individuals do not have a lump sum of cash to contribute in a single year. Contribution limits to the plan vary by state.

One of the disadvantages Kevin and Natalie notice about the 529 plan is that they can only contribute to the account using cash or check. If they wanted to gift stocks or bonds, they would have to liquidate them and then give the cash. The money can also only be used for college, so if they decide on an expensive private school, they won't be able to use the money from the plan to help with costs. The investment choices in a 529 plan are typically limited to basic investment vehicles like mutual funds and investment options vary by state.

Coverdell Accounts

A Coverdell Education Savings Account, or ESA, is an education savings account with income limitations--$110,000 for an individual or $220,000 for a married couple filing jointly. The contribution limit is $2,000 per child under 18 years of age. These two bits of info strike Kevin and Natalie as somewhat limiting--$2,000 isn't much to contribute each year, and income limitations aren't ideal.

Contributions in the ESA are not tax-deductible, but the earnings grow tax-free. Withdrawals are tax-free for qualified educational expenses such as book, supplies, tuition, and fees. But you have to take the money out before the beneficiary turns 30. And if their son takes the money out for non-educational expenses, he will pay income tax plus a 10% penalty.

One advantage to the ESA is that it can be used for any educational expense from kindergarten through college, so if Kevin and Natalie opt for an expensive private school, they could pull from the ESA to help with those costs.

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