What an Education Savings Account Does

An education savings account (ESA) is a tax-advantaged account where you set aside money specifically for a student's education costs. The money you put in grows tax-free, and you withdraw it tax-free when you pay for tuition, books, room and board, or other may have access to education expenses. The account belongs to the student, but a parent, grandparent, or other adult opens and manages it until the student turns 18 or 21, depending on the account type.

The main appeal is the tax break: you don't pay federal income tax on the earnings, and in most states you don't pay state income tax either. That means your money compounds faster than it would in a regular savings account. The tradeoff is that the money must go toward education, or you'll owe taxes and a penalty on the earnings if you withdraw it for something else.

There are two main types: a Coverdell ESA (a federal account with strict contribution limits) and a 529 plan (a state-sponsored account with much higher limits). Most families use a 529 because you can save more money and the rules are more flexible.

Key Takeaways

  • A 529 plan lets you save up to $235,000 per student (the limit varies slightly by state) with no annual contribution cap, while a Coverdell ESA caps contributions at $2,000 per year per student.
  • You open a 529 through your state's plan website or through a financial company that administers your state's plan, and you'll need the student's Social Security number and your own tax ID.
  • Money in a 529 grows tax-free and comes out tax-free for tuition, fees, books, room and board, computers, and certain K-12 private school or apprenticeship costs.
  • If the student doesn't use all the money, you can transfer it to a sibling, a cousin, or another family member without penalty, or roll it into a Roth IRA under new rules.
  • Opening an account takes 15 to 30 minutes online, and you can start with as little as $25 or $50, though some plans have no minimum.

Choosing Between a 529 Plan and a Coverdell ESA

A 529 plan is the right choice for most families. You can contribute up to $235,000 per student (the exact limit depends on your state), with no annual cap. The money can be used for college, graduate school, K-12 private school tuition, apprenticeships, and student loan repayment up to $35,000 lifetime. You open it through your state's plan or through a financial company that manages your state's plan, and you control the account until the student is an adult.

A Coverdell ESA is smaller and more restrictive. You can only contribute $2,000 per year per student, and the account must be spent by the time the student turns 30 or you'll owe taxes and a 10% penalty on the earnings. The money can cover K-12 private school tuition and college, but not apprenticeships or student loan repayment. A Coverdell makes sense only if you're saving a small amount and want more control over how the money is invested (Coverdale accounts typically offer more investment choices than 529s).

For most people, a 529 is simpler and more powerful. You can save more, the rules are more forgiving, and you have more options for what to do with unused money.

How to Open a 529 Plan

Start by visiting your state's 529 plan website. Every state runs at least one plan, and you can use any state's plan regardless of where you live or where the student will go to school. Search "[your state] 529 plan" to find the official site. Common plans include New York's Direct Plan, California's ScholarShare, and Texas's Lonestar 529.

On the plan's website, click the button to open a new account. You'll need:

  • Your name, address, and Social Security number or tax ID
  • The student's name, date of birth, and Social Security number
  • Your relationship to the student (parent, grandparent, etc.)
  • A bank account or credit card to fund the account

The form takes 15 to 30 minutes. Once you submit it, the plan will send you a confirmation email with your account number and login credentials. You can then log in and make your first deposit, which can be as small as $25 or $50 depending on the plan.

If you prefer to work with a financial advisor or investment professional, you can also open a 529 through a brokerage like Fidelity, Vanguard, or Charles Schwab. These firms manage the account on your behalf and may offer more investment options, but they typically charge higher fees than direct plans.

Choosing How Your Money Is Invested

Once your account is open, you choose how the money is invested. Most 529 plans offer age-based portfolios as the default: the plan automatically shifts your money from stocks to bonds as the student gets closer to college age. This is a hands-off approach and works well if you don't want to think about it.

You can also choose individual investment options—stock funds, bond funds, money market funds—and build your own mix. If you're saving for a young child and have time before college, a stock-heavy portfolio will likely grow faster. If the student is in high school, a more conservative mix protects the money you've already saved.

You can change your investment choice once per calendar year, or whenever the account owner or student changes (for example, if you open a new account for a younger sibling). Don't overthink this: age-based portfolios are designed to work for most families, and you can always adjust later.

Making Deposits and Growing Your Account

You can deposit money into your 529 whenever you want. There's no annual deadline like there is with a Coverdell ESA. You can set up automatic monthly transfers from your bank account, make a lump-sum deposit, or contribute whenever you have extra money. Some families fund their 529 with tax refunds, birthday money from relatives, or a percentage of their annual bonus.

Money in the account grows tax-free. You don't report the earnings on your federal tax return, and most states don't tax the earnings either. When you withdraw money for a may have access to education expense, the entire withdrawal—both your contributions and the earnings—comes out tax-free.

If you withdraw money for something other than education, you'll owe federal income tax on the earnings portion plus a 10% penalty. Your contributions always come out tax-free, but the growth is taxed and penalized. This is why it's important to be reasonably confident the money will be used for education before you open the account.

What Happens If the Money Isn't Used for College

If the student doesn't use all the money—because they got a scholarship, chose not to go to college, or simply didn't spend it all—you have several options. You can transfer the remaining balance to another family member, including a sibling, cousin, niece, nephew, or even a parent or grandparent, without any tax or penalty. This is called a 529-to-529 transfer, and it's one of the biggest advantages of a 529 plan.

As of 2024, you can also roll up to $35,000 of unused 529 money into the student's Roth IRA, as long as the account has been open for at least 15 years. This lets you save the money for retirement instead of education, though there are annual contribution limits to the Roth.

If you don't transfer the money and don't roll it into a Roth, you can withdraw it, but you'll owe income tax and a 10% penalty on the earnings. Your contributions always come out tax-free.

How a Coverdell ESA Works (If You Choose This Route)

If you decide a Coverdell ESA is right for you, open one through a bank, brokerage, or investment company. You'll need the student's Social Security number and your tax ID. The process is similar to opening a 529: fill out a form, choose your investments, and make your first deposit.

You can contribute up to $2,000 per year per student, and the money must be spent by the time the student turns 30. If there's money left over, you can transfer it to another family member's Coverdell (if they're under 30), or you'll owe taxes and a 10% penalty on the earnings.

Coverdale accounts often offer more investment flexibility than 529 plans—you might be able to invest in individual stocks, for example—but the contribution limits are much lower. For most families, the 529's higher limits and more flexible rules make it the better choice.

Frequently Asked Questions

Does opening a 529 hurt my child's chances of getting financial aid?

A 529 in the parent's name has minimal impact on financial aid. A 529 in the student's name reduces aid may be able to access more significantly because colleges count student assets more heavily. If you're concerned about aid, open the account in a parent's name, not the student's.

Can I use 529 money for room and board?

Yes, if the student is at least a half-time student at an accredited college or university. Room and board counts as a may have access to expense, along with tuition, fees, books, and computers. Check your school's cost of attendance to see what the plan allows.

What if I want to change the student on my 529 account?

You can change the beneficiary to another family member without tax or penalty. This is useful if you opened an account for one child and want to move unused money to a sibling. The plan will issue you a new account number and send updated tax documents.

Do I get a tax deduction for 529 contributions?

Federal tax law does not allow a deduction for 529 contributions. However, 34 states and Washington D.C. offer a state income tax deduction or credit for contributions to their own 529 plans. Check your state's plan website to see if you may have access to.

Can grandparents open a 529 for a grandchild?

Yes. Grandparents can open and fund a 529 for any grandchild. If the grandparent opens the account, it's treated as a parental asset for financial aid purposes, which is better than if the grandchild owned it. Some grandparents coordinate with parents to avoid overfunding the account.