Overview: Two primary tax-advantaged tools exist specifically for education funding — Coverdell ESAs and Section 529 plans — and a working agent needs to understand both their tax treatment and how they compare.

Coverdell Education Savings Accounts

A Coverdell ESA (formerly "Education IRA") is a trust or custodial account that grows tax-free and distributes tax-free when used for qualified education expenses. The contribution limit is a modest $2,000 per beneficiary per year — a ceiling that has not been inflation-adjusted since 2002. If multiple family members contribute to a single child's ESA, the total from all contributors combined cannot exceed $2,000 in any year.

Income limits apply to contributors: the full $2,000 may be contributed if MAGI is under $95,000 (single) or $190,000 (married filing jointly), with a phase-out to zero at $110,000 and $220,000, respectively. Corporations and trusts can contribute regardless of income.

Coverdell ESAs offer exceptional flexibility in eligible expenses. Unlike 529 plans, there is no annual dollar cap on K-12 withdrawals — the full account can be used for elementary or secondary school tuition, tutoring, uniforms, transportation, computer equipment, or special needs services. At the college level, room and board, books, and technology qualify as well.

Contributions must stop when the beneficiary turns 18, and all funds must be distributed — or rolled to a qualifying family member — within 30 days of the beneficiary's 30th birthday. A Coverdell ESA can be rolled into a 529 plan tax-free. Non-qualified distributions trigger ordinary income tax on the earnings portion plus a 10% penalty on the earnings.

Section 529 Plans

A Section 529 plan is a state-sponsored, tax-advantaged account for education savings. Contributions are made after-tax (no federal deduction, though over 30 states offer state deductions or credits for in-state plan contributions), earnings grow tax-deferred, and qualified distributions are completely tax-free federally.

There is no IRS annual contribution limit per se — instead, contributions are treated as completed gifts subject to the annual gift tax exclusion of $19,000 per donor per beneficiary (2024). The unique "superfunding" provision allows five years' worth of gifts to be contributed at once — up to $95,000 individually or $190,000 for a married couple — without triggering gift tax, as long as no other gifts are made to that beneficiary for five years.

Each state sets its own lifetime aggregate cap, which ranges from approximately $235,000 (some states) to over $600,000. Account ownership is not limited to the state where the plan is domiciled; a family in Ohio can contribute to a Utah plan to take advantage of superior investment options.

Qualified higher education expenses include tuition, fees, books, room and board (half-time enrollment required), and computer equipment. Up to $10,000 per year can be used for K-12 tuition. Up to $10,000 lifetime can repay student loans of the beneficiary or a sibling. The SECURE Act 2.0 added a valuable new exit strategy: unused 529 funds can be rolled into a Roth IRA owned by the beneficiary, tax- and penalty-free, subject to a $35,000 lifetime limit, a 15-year minimum holding period for the 529 account, and the standard annual Roth contribution limits ($7,000 in 2024).

Non-qualified withdrawals from a 529 plan trigger ordinary income tax on the earnings portion plus a 10% federal penalty on the earnings. The original principal is always returned tax- and penalty-free.

529 Savings Plans vs. Prepaid Tuition Plans

There are two types of 529 plans. Education savings plans — by far the more common — invest contributions in market portfolios, offering flexibility in where funds can be spent and how they grow, while subjecting account value to market risk. Prepaid tuition plans, offered by approximately nine to ten states, allow families to lock in current tuition rates at designated in-state public colleges, eliminating tuition inflation risk — but restricting use to those institutions and covering only tuition and fees (not room and board or books).

How Education Accounts Affect Financial Aid

For FAFSA purposes, 529 plans and Coverdell ESAs owned by a parent count as parental assets and reduce aid eligibility by at most 5.64% of the account value — a favorable treatment. Student-owned accounts are assessed at 20%. Under the FAFSA Simplification Act, qualified distributions from grandparent-owned or third-party 529 accounts are no longer reported as student income on the FAFSA, eliminating the historical penalty for grandparent giving.

FAQ

What happens to a 529 if the child gets a scholarship?
If the beneficiary receives a tax-free scholarship, you can withdraw up to the scholarship amount from the 529 without the 10% penalty. The earnings portion is still subject to ordinary income tax. Alternatively, you can change the beneficiary, leave the funds for future use, or (after 15 years) begin rolling unused funds into a Roth IRA.

Can the same expenses be used for both a 529 tax-free distribution and an education tax credit (AOTC or LLC)?
No — this is "double dipping." If you claim the American Opportunity Tax Credit on $2,500 of tuition, those same expenses cannot also be used to justify a tax-free 529 distribution. You must choose which tax benefit to apply to each dollar of expense.

Can a Coverdell ESA and a 529 plan both be used for the same beneficiary?
Yes. There is no prohibition on having both. Many families use a Coverdell for K-12 expenses (where flexibility is greater) and a 529 for college (where account size can be larger).