Comparing Education Savings Accounts

Education is expensive, but putting an education savings plan in place early can give you and your child a valuable head start. Accounts designed for education savings (such as 529 plans and Coverdell Education Savings Accounts) can potentially provide tax advantages when used for qualified education expenses like tuition or certain school-related expenses like books, supplies, computers, and room and board.

Ahead, we'll look at three common types of accounts that can be used for education and compare the contribution limits, investment options, tax considerations, and more.

Most states have a 529 plan that generally offers federally tax-deferred growth and tax-free withdrawals as long as you use the money to pay for qualified education expenses. There's no annual contribution limit, but each state sets their own lifetime limit per beneficiary that restricts new contributions once the account reaches a certain value (in the range of $400,00 to $550,000). However, federal gift tax rules apply to 529 plan contributions (more about gift tax in the chart below).

529 plans aren't limited to college tuition and expenses. For example, up to $10,000 a year from a 529 plan can be used to pay for an eligible elementary, middle, and high school expenses, including public, religious, and private school tuition. Additionally, the beneficiary of a 529 account can pay off up to $10,000 in student loans (the lifetime limit) without incurring any penalties or tax consequences.

A Coverdell ESA is another tax-advantaged account. ESA programs offer the ability for investments to potentially grow tax-deferred, and withdrawals are generally free from taxes as long as you use the money for qualified education expenses. Tax-free withdrawals apply to eligible elementary and secondary education expenses (including public, private, and religious schools), as well as college expenses.

There is, however, a bit of a catch with eligibility due to income limitations. The maximum annual contribution to a Coverdell account is $2,000 for joint filers with a modified gross income (MAGI) up to $190,000 and is gradually reduced for MAGI between $190,000 and $220,000. Incomes above $220,000 are ineligible to contribute to a Coverdell ESA.

Though a custodial account is not specifically designated for education expenses, it can certainly be used for them. Custodial accounts like the Uniform Gift to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) are typically established for a child and are managed by a custodian. Typically, when a child reaches age 18, 21, or up to age 25, depending on the state of residence, legal control of the account transfers from the custodian to the beneficiary.

The main benefit of the account is parents can take advantage of the annual gift tax exclusion to fund the account while maintaining control over how the money is invested and spent while the child is a minor. Custodial accounts also provide parents with more flexibility on how the money is spent, as long as the money is used for the child's benefit.

If you've already opened an education savings account, review your plan (and your overall savings and investment strategy) annually to make sure it aligns with your current education needs and goals.

For example, if you already have a college savings account like an ESA, would opening a 529 Plan or custodial account help you reach your goals sooner and give you greater tax benefits, due to higher contribution limits?

If you have a new child, grandchild, or other beneficiary, do you need to set up a new education savings plan for them? In addition to a 529 or ESA (for qualified education costs), do you need another account (such as a custodial or regular savings account) to save for "nonqualified" costs your child might have while in school such as off-campus housing, car repairs, travel, or club dues?

Planning, investing, and saving for college can feel overwhelming, but knowing your choices and getting an early start can help you boost potential savings and make progress toward your goal. Using accounts designed for education savings can potentially offer valuable tax advantages— and starting early allows you to take advantage of the power of compounding.