Planning for college

John calls Dave asking for some information on financial planning for college. In the process, Dave explains the differences between an Education Savings Account (ESA) and a 529 plan.

QUESTION: John calls in from Bismarck, North Dakota, with questions about financial planning for college. He asks Dave about the differences between an Education Savings Account (ESA) and a 529, and Dave is happy to explain.

ANSWER: Well, the ESA is limited to $2,000 per year, per child. It has complete flexibility, meaning you can invest it in whatever you like and you can move it—roll it over—to another one if you don’t like that mutual fund, as an example. We recommend you put that in good growth stock mutual funds, and we recommend that you do that for the first $2,000 per year.

There are several types of 529 plans. There’s only one type that I would recommend, and it’s the type again that has complete flexibility and you control the investments. Some of the states have 529 plans that are prepaid tuition. I never recommend that. It’s a bad idea. You don’t want the state managing anything for you, because you won’t get anywhere near the returns you’d get if you managed it yourself. Other types of 529s lock you into a certain kind of investment the whole time, or they move the investment based on the age of your kid. I don’t want anybody doing that crap. I want you controlling you money.

Now most of the 529s, they vary from state to state, but most of them that have flexibility that you control the investment in allow you to contribute up to $10,000 a year. Both those and the ESAs grow completely tax-free on the growth as long as they’re used for higher education. They can be transferred to a sibling if the kid doesn’t go to school, so a little brother or sister can use the money. And if they get scholarships, keep up with the value of the scholarships. You’ll be allowed to withdraw that much and refund yourself for the scholarship amount without penalty or taxes on the amount you withdraw there.

That’s kind of an overview. Both of those are fine, just make sure if you’re doing a 529 that you’re doing the kind you control from top to bottom.