It’s been a while since I’ve written about college savings and the best ways to pay for college, so I thought I’d add another installment to the series. Today I’m going to tackle a topic for parents who want to save for their children’s college using the two most common methods, the ESA and the 529. Both are specific types of investment accounts that allow you to invest money (stocks, bonds, mutual funds, etc.) for your child’s college education and both have their pros and cons. Today, we’ll go through the basics of each and explain some of the differences.
Why an ESA or 529?
There are all kinds of ways to save for college – everything from a piggy bank to a simple savings account to a savings bond or CD. So why would you step into an ESA or 529? Simply put – growth! While both of these investment types have a greater risk than a savings account or CD, there is also a lot greater potential for growth. If you’re starting out early (as I hope), you’ve got as many as 18 years to ride out the risks of ups and downs in the markets.
College saving with an ESA or 529 is very similar to the approach of saving for retirement using a 401k or IRA – they are LONG TERM plans. Both of these plans also have the nice perk of being “tax advantaged,” meaning that the interest you earn from these investments is tax free (you don’t have to pay taxes on the money they earn). Especially if you save a good amount for your child’s college, this is a big benefit!
ESA: the Basics
An ESA (which stands for “Educational Savings Account”) is a specialized savings account that allows you to save money toward a broad range of educational expenses. You can use this money to pay for things starting with Kindergarten, making it attractive for parents sending their kids to private school. “Educational expenses” are also defined rather broadly, allowing the funds to be used to pay for things like room and board, books, computers, etc.
The negatives of an ESA are that all the funds must be used by the time the child reaches age 30 so for those who may be a non-traditional student, this makes ESAs a bad choice. ESAs also limit contributions to $2,000 per year so if you’re starting out late in the game (maybe you have a teenager), you can’t play catch up very easily. Beyond these two items, an ESA is a pretty simple and awesome way to save for education.
529: the Basics
A 529 plan is also a specialized savings plan that allows you to save money, but the expenses it can be used for are limited to tuition, room, board and books. You also can’t use the money for anything except “post-secondary” education (college). But that’s not always a bad thing. This limitation can help keep parents from dipping into these funds prematurely and it truly focuses the saving efforts toward college.
A couple of big pluses exist for the 529. First is its lack of a $2,000 contribution limit. Parents of teenagers or those who want to make a big one-time payment are able to be more aggressive in saving. There is also no age limit for the beneficiary to use the funds for college – so if your child decides to travel the world for a few years, then head off to college at the age of 28, you will still be able to help him/her even past that 30th birthday when they would start their junior year.
We have a 529 plan we opened for our daughter when she was 6 months old. Why the 529? We chose a 529 primarily because we hope to be able to save more than $2,000 per year at some point. So far we have invested conservatively, using three different types of mutual funds. We’ve put in $2,800 at the time of this writing and it is currently worth $3,315 – an annualized return of 8.19% per year over the three years it has been in place. And this has been during some pretty rough times in the economy! Tell me what bank will pay you 8% on a CD these days?
As you can see, the 529 and ESA are very similar, but each has its distinct advantages and disadvantages. If you are a parent who is able to help your child save for higher education, don’t overlook the possibilities (both in investment growth and tax savings) of an ESA or 529. They are easy to set up, simple to keep up and will help your investment in your child’s future go a lot farther!