Financial Freedom Insights: Issue 17

How Do ESAs Affect Financial Aid Eligibility?

Why Use an ESA to Save?

If you set up your finances so that you put away a certain amount each month or year to save for your child’s education, you can build up a significant amount without even thinking about it.

Why not just use a high-yield savings account or regular brokerage account? You could, but if you do, you will have to pay tax on the earnings. Look at the interest rates on high-yield accounts to decide whether it is a better option.

The Different Types of ESAs

The options for saving for your child’s college or K-12 education include a 529 plan (probably the most popular), a Coverdell account, an Education Scholarship Account, and a custodial accounts.

The 529 Plan

State governments typically sponsor 529 plans, and you can usually deduct your contributions from your state income tax (if you choose your state’s plan). Your money will grow tax-free, and if you use the funds for qualified education expenses, you can withdraw them tax-free as well. You can save as much as you want; however, the investments in your account are limited to those investments offered by the state.

What if your child does not end up going to college? Don’t worry. You can put up to $35,000 from a 529 into a beneficiary Roth IRA without paying taxes or penalties as long as the 529 account has existed for at least 15 years. Only a certain amount can be moved at a time, however, and in 2026, the limit is $7,500 per year ($8,600 if you’re 50 or older).[1]

The Coverdell ESA

A Coverdell ESA has the same tax benefits as a 529 plan, but it has different rules. You have to be below a certain income level to use a Coverdell, and you can’t contribute more than $2,000 per year to the account. Coverdell ESA funds can either be withdrawn before your child turns 30 or rolled over to another eligible beneficiary in the family.[2]

Education Scholarship Accounts

Education scholarship accounts, or ESAs, are also funded by state governments. These accounts are used if you want to withdraw your child from a public school and pay private school tuition. Not all states offer these types of accounts.

Roth IRAs

Roth IRAs allow you to save with after-tax dollars and your money grows tax-free. You can also withdraw money from a Roth IRA for educational purposes or any other purpose without paying a penalty — though you’ll still have to pay income taxes on the earnings unless you withdraw the money after age 59½.

There are no restrictions on the investments you fund with a Roth IRA (stocks, bonds, exchange-traded funds (ETFs), index funds). However, if you invest through a broker, consider any fees that you may have to pay.

If your child does not end up going to college, you can use the funds in a Roth IRA for your retirement. That’s not the case for other ESAs, which must be used only for educational expenses.

Custodial Accounts

Custodial accounts — also known as UGMAs (for the Uniform Gifts to Minors Act) and UTMAs (for the Uniform Transfers to Minors Act) — are managed by you for your child. These accounts can also invest in a multitude of vehicles, and there is no limit to how much money you can put into the account. 

Your child assumes the ability to withdraw the money in the account for college or anything else when they reach "termination age" — typically 18, 21, or 25 depending on your state.

Custodial accounts don’t offer the tax benefits of ESAs, but they can be used to fund expenses that those plans don't cover.

Distributions for K Through 12

With a 529, you are limited to $10,000 per year for qualified K-12 expenses (there is no limit on withdrawals for qualified college expenses). Coverdell ESAs do not have any limits on educational expenses at elementary or secondary schools.

Which Option Should You Choose?

If you don’t need to save much and want control over how your money will be invested, a Coverdell ESA might work. If you want to save more than $2,000 a year, a 529 plan might be better.

A custodial account could work well if your child will have additional expenses above and beyond the norm. If you’re not sure whether your child will attend college or what the costs might be, you might consider using a Roth IRA.

Frequently Asked Questions

1. Will a 529 plan affect my child’s eligibility for federal financial aid?

Yes. If a parent owns the 529 plan, it is considered a parent asset and could reduce financial aid eligibility by up to 5.64% of the account value. If owned directly by the student, it counts as a student asset and can reduce eligibility by up to 20%. However, it is still a good idea to save for your child’s education because it could reduce the amount of student loans you need to use later.

2. What happens to funds in a 529 plan if the child chooses not to go to college?

You can roll over up to $35,000 of unused 529 funds into a Roth IRA for the beneficiary without paying taxes or penalties, subject to conditions.

3. What is the key difference between a 529 plan and a Coverdell ESA?

529 plans have no annual contribution limits and are limited to state-selected investment options, though K-12 tuition withdrawals are capped at $10,000 per year. Coverdell ESAs cap contributions at $2,000 annually per person and restrict eligibility based on income. Coverdell ESAs offer greater investment flexibility and no specific annual limit for qualified K-12 expenses.

4. Can a Roth IRA be used to save for college expenses?

Yes. You can withdraw penalty-free from a Roth IRA to cover qualified education expenses. However, earnings withdrawn before age 59½ are subject to income tax. If unused for college, the money remains in the account for retirement.

5. How do Custodial Accounts (UGMA/UTMA) differ from traditional education savings accounts?

Unlike 529s or Coverdell ESAs, custodial accounts do not offer tax-free growth or withdrawals for education. However, they have no contribution limits and can be used for non-educational expenses. Control of the funds automatically transfers to the beneficiary once they reach adulthood (usually 18, 21, or 25, depending on state law).

Sources

[1] Saving for College, October 14, 2025, “How Do 529 Plans Affect Financial Aid?” https://www.savingforcollege.com/intro-to-529s/does-a-529-plan-affect-financial-aid. Accessed August 15, 2026.

[2] Jeff White, August 6, 2026. “529 to Roth IRA: Rollover Rules, Conversion Guide, and FAQs” https://www.savingforcollege.com/article/roll-over-529-plan-funds-to-a-roth-ira. Accessed August 15, 2026

[3] IRS, n.d. “Topic no. 310, Coverdell education savings accounts,” https://www.irs.gov/taxtopics/tc310. Accessed August 15, 2026.