Dear Dave,

We have two daughters, and we’ve started thinking about financial planning for college. What are the differences between an Education Savings Account and a 529 plan?

John

Dear John,

I’m glad you’re thinking ahead and planning for the future. Here’s a quick overview of the two.

The Education Savings Account (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. I use that example because I recommend using good growth stock mutual funds and that you do this for the first $2,000 invested per year.

There are several types of 529 plans, and there’s only one that I would recommend. It’s the kind that has complete flexibility, where you control the investments. Some states have 529 plans that are prepaid tuition, and I never recommend those. 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 your money.

Most of the 529s vary somewhat from state to state, but the majority have flexibility that allows you to control the investment while contributing 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 also be transferred to a sibling if the kid doesn’t go to school, so a little brother or sister can use the money. If they get scholarships, make sure you keep up with the value of these. You’ll be allowed to withdraw that amount and refund yourself for the scholarship amount without penalty or taxes on the amount withdrawn.

In short, both the ESA and 529 are fine ways to save for college. Just make sure if you’re doing a 529 that you choose the kind you control from top to bottom!

—Dave