Outside of retirement plans, there are other tax-beneficial plans available to people saving for education or for individuals considered disabled. This chapter covers:
Coverdell education savings accounts (ESAs) provide a tax-friendly way to save for a child’s education. ESA funds can be used to pay for costs related to virtually any type of education, including grade school, middle school, high school, vocational school, and college.
An annual non-deductible contribution limit of $2,000 per child per year may be made into a Coverdell. Similar to Roth IRAs, contributions are non-deductible, and high-income earners (in 2025, $220k+ for a family) are prohibited from contributing. Contributions can be made until the child reaches age 18.
Once contributed, the assets are invested and grow tax-sheltered. When education costs come up, funds can be withdrawn to pay them. Coverdell distributions used to pay for educational expenses (known as qualified expenses) are not subject to taxation. This is the main benefit of these accounts: investment gains are typically taxable, but not in a Coverdell ESA (as long as distributions are used for qualified expenses). If a withdrawal is not linked to qualified education expenses, ordinary income taxes apply and there is an additional 10% penalty.
All assets in a Coverdell ESA must be distributed by the time the account beneficiary reaches age 30. If the beneficiary won’t have educational expenses, assets can be rolled over into another family member’s Coverdell ESA, as long as that family member is under age 30.
529 plans, also known as qualified tuition programs (QTPs), are very similar to Coverdell ESAs but are mainly used for college expenses. Each U.S. state sponsors its own 529 plan.
Two general 529 plan types exist: prepaid tuition plans and college savings plans.
Prepaid tuition plans are exactly what they sound like. Investors contribute money for a future college student and “prepay” tuition at today’s rates instead of paying later (when tuition rates would likely be higher). These plans reduce the risk of rising college costs, which have risen much faster than inflation in recent years.
College savings plans involve investing in state-approved funds, such as mutual funds. Investors typically have a range of choices, including everything from money market funds to aggressive growth funds. Many plans also offer target date funds, which are structured around the year the funds are expected to be needed (for example, a 2040 fund for a student projected to attend college in 2040). Target date funds typically start out more aggressive and become more conservative over time. Many eventually shift heavily into money market funds as the target date approaches.
Because saving for college is usually a long-term goal, 529 plans limit frequent trading. The plan participant (the person managing the plan, discussed below) may make only two changes to the 529 investment allocation per calendar year. The plan participant can also move from one state’s 529 plan to another state’s 529 plan once per calendar year.
There are two parties in each 529 plan: the plan participant and the beneficiary.
The plan participant plays a role similar to a custodian in a custodial account. This is often a parent or other family member managing assets for a child. The plan participant chooses the investments and requests distributions when educational expenses occur.
The beneficiary is the person the 529 assets are intended to support, often the plan participant’s child or another close family member.
One unique aspect of 529 plans is how much control the plan participant keeps. Assets placed into the plan remain the property of the plan participant, no matter how old* the beneficiary is. Unlike UGMA and UTMA accounts, there is no requirement to turn the assets over to the beneficiary once they reach adulthood. The plan participant is also under no obligation to distribute the funds. If the child doesn’t go to college, there’s no requirement to give them the money.
*529 plans have no age requirement. Any adult can open a 529 account for a beneficiary at any age.
The plan participant also controls who the beneficiary is. Beneficiary changes can be made without tax consequences if the new beneficiary is a family member. The IRS considers the following as eligible family members for non-taxable beneficiary changes:
Contributions to 529 plans are made with after-tax money at the federal level. That means contributions do not reduce federal income tax liabilities. However, some states provide a state tax deduction for contributions. The key word is some - several states do not offer a state tax deduction (especially those without an income tax).
Although contribution limits are generally not a practical concern, gift taxes may apply. For the tax year 2026, a person gifting more than $19,000 to someone other than their spouse may be subject to federal gift taxes. If a grandmother contributes more than $19,000 to her grandchild’s 529 plan, she may owe taxes.
There is a way to avoid gift taxes even if the amount contributed is more than $19,000. The IRS allows a one-time contribution of up to five times the annual limit. For example, a grandmother could contribute up to $95,000 ($19,000 x 5) to her grandchild’s 529 plan and avoid gift taxes. If she contributes anything more in the next five years, she would be subject to taxes.
Once funds are contributed and invested, the assets grow tax-deferred over time. The IRS cannot tax any capital gains or dividends received as long as the assets remain in the account. 529 plans generally require automatic reinvestment of capital gains and dividends.
529 plans have contribution limits, but they vary by state, and you won’t need to know them for the exam. These limits are typically quite high. For example, California’s cumulative contribution limit per person is $529,000. Also, 529 plans do not have phase-out rules, so even high-income earners can contribute.
Recent changes to 529 plan distribution rules were enacted under the One Big Beautiful Bill Act (OBBBA), a federal law that expanded the definition of qualified educational expenses while preserving the tax-deferred growth and tax-free treatment of qualified withdrawals.
Distributions (withdrawals) are not taxable as long as the funds are used for qualified educational expenses. The definition of a qualified 529 expense is narrower than it is with Coverdell ESAs (where virtually all education-related expenses are qualified). Qualified 529 expenses typically include:
529 plans are primarily used for college expenses. However, up to $20,000 per year can be used for private, public, or religious schools below the college level*. K-12 qualified expenses are expanded under OBBBA to include books, curriculum and online materials, tutoring and educational classes, standardized test fees, dual-enrollment fees, and certain educational therapies for students with disabilities.
The expanded expense categories apply to distributions made after enactment; however, a 2025 reimbursement window allows distributions taken later in 2025 to reimburse earlier 2025 expenses that now qualify under OBBBA. If college savings plan funds are not used for education, the account owner is subject to ordinary income taxes and a 10% penalty (only on the gains; the basis is always tax-free). However, if the beneficiary receives a scholarship and no longer needs the 529 plan, assets may be distributed without the 10% penalty (ordinary income taxes will still apply to gains). Generally, distributions must be taken in the same calendar year a college expense is assessed.
*When paying for educational expenses below the college level (K-12), qualified expenses are no longer limited to tuition. Under current law, certain additional K-12 costs may qualify, subject to annual limits. Nonqualified expenses remain subject to ordinary income taxes and a 10% penalty on earnings.
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