Are you interested in learning more about a Coverdell Education Savings Account? if yes then this article is for you.
What’s a Coverdell education savings account, and how does it work?
A Coverdell ESA is a tax-deferred account that lets you save for a child’s education. Because it’s tax deferred, you won’t have to face any potential taxes on the funds until they’re distributed (and if the distributions are less than or equal to the qualified educational expenses for the given year, you won’t owe taxes on them at all).
There’s a cap on how much you can contribute each year. And you’ll have to designate a beneficiary who is younger than 18 or has special needs.
A Coverdell Educational Savings Account (ESA) is a great way to save for your child’s college education because they offer great tax savings and you control how and where you invest your contributions. This is in contrast to a 529 college savings plan, in which investment options are limited to the options available in your
Let’s take a look at how Coverdell education savings accounts work by answering some common questions.
Who can contribute, and what is the contribution limit?
If you have a modified adjusted gross income of less than $110,000 ($220,000 for couples filing a joint tax return), you may be able to contribute to a Coverdell ESA. Parents, grandparents and even family friends can make contributions toward the child’s education, as long as they meet those income thresholds.
Organizations, including trusts and corporations, can contribute too, according to the IRS.
The annual contribution limit is typically $2,000 per year for each designated beneficiary, though the limit could be reduced depending on your income.
But it’s important to know that the total contribution limit is per beneficiary rather than per account. So if a parent, grandparent and aunt all open separate Coverdell ESAs for the same child, the total contributions to all three accounts combined can’t be more than $2,000 per year (assuming each contributor meets applicable income requirements).
And once the beneficiary turns 18, you can’t make any more contributions to the Coverdell account, unless the beneficiary has special needs.
What expenses can a Coverdell education savings account pay for?
A Coverdell ESA can be used to pay for qualified educational expenses at an “eligible educational institution.” That includes elementary and secondary schools — ESAs aren’t just for higher education.
For elementary school or secondary school, the ESA can pay for …
Tuition and fees
Books, supplies and equipment
Special needs services (for beneficiaries with special needs)
Computers and computer equipment
And it’ll cover the following items, if the elementary or secondary school requires them (even if the school provides it at the student’s expense):
Room and board
Supplementary items and services, including extended day programs
For students attending a college, university or vocational school, an ESA can be used for …
Tuition and fees
Books, supplies and equipment
Special needs services (for beneficiaries with special needs at an eligible school)
Expenses for room and board for students enrolled in school at least half-time
Computer and computer software
When do funds have to be withdrawn?
Any assets left in the Coverdell account must be distributed by the time the designated beneficiary turns 30 — unless the beneficiary has special needs. If the beneficiary dies, the remaining assets must be distributed within 30 days of their death.
What is the difference between an education savings account and a 529 account?
If you’re saving for a child’s education, you may also decide to open a 529 plan, also known as a qualified tuition program, which is on our list of the best college savings plans.
If you’re trying to compare these accounts, consider these differences.
Income restrictions — Coverdells have an income threshold to be eligible to contribute. But 529 plans have no income restrictions for individuals.
Contribution limits — Unlike Coverdell ESAs, 529 plans don’t have a set contribution limit either. Instead, the IRS says that the contributions to a 529 can’t be more than the amount necessary to pay for qualified education expenses. Some states have different limits though, so it’s best to check on the plan you want to open.
Potential uses — 529 plan distributions can be used to pay for qualified postsecondary education expenses, like tuition and fees. But if you want to use the money for elementary or secondary school, there are some limitations. For example, you can withdraw only up to $10,000 per year to pay for tuition (and only tuition) for elementary or secondary school. Compared with a Coverdell ESA, many more categories of expenses can be covered. A Coverdell ESA may also allow you to withdraw more per year for qualified educational expenses for private elementary, middle or high school.
Taxes — Qualified contributions to both Coverdell ESAs and 529 plans are tax deferred and not deductible on your federal income taxes. And the qualified distributions for both savings plans are tax exempt as long as you use them on qualified expenses (otherwise they’re subject to a 10% penalty).
If you want to maximize your savings, you can open both a Coverdell ESA and a 529 plan. You can contribute to both account types in the same year for the same designated beneficiary (whereas, multiple accounts of the same type would be limited).
When Can You Open a Coverdell Education Savings Account?
You can open a Coverdell at any time for any child under the age of 18. You need your beneficiary’s full name, date of birth, Social Security number and address. Contributions to the account can be made by anyone, and they do not have to be related to the beneficiary. In fact, a corporation or partnership can even contribute.
The money in a Coverdell ESA must be distributed before the beneficiary turns 30. You have until 30 days after that birthday to distribute the assets. The one exception to this rule is when the beneficiary has special needs. That is dealt with on a case-by-case basis.
Where Can You Open a Coverdell Education Savings Account?
You can open the ESA at a financial institution of your choosing. If a bank or investment institution offers IRAs, it will usually also offer ESAs. Many charge an annual maintenance fee, and some may require a minimum annual contribution. You should compare offerings to see which one works the best for you and your financial needs.
Other Places to Open a Coverdell ESA Plan Account
Mutual Fund Houses, banks, credit unions, and other options. Some large mutual fund firms also offer Coverdell Accounts. These may be good options, depending on which types of investments you choose to hold in your accounts. You can’t go wrong opening an account with the major firms like T. Rowe Price, Charles Schwab, and similar firms.
Many banks and credit unions may also offer these accounts. I recommend researching these options before investing with them. Many banks and credit unions do not offer as many investment options, and they may have slightly higher fees than you can find at some of the larger investment firms. In general, I find it is better to keep your investments at a dedicated investment firm – there are usually more investment options and lower fees.
How to Open a Coverdell ESA Plan Account
Coverdell ESA plans can be opened at almost any brokerage firm or bank. You will need the SSN of the beneficiary to open the account as well as other personal information, including name, date of birth, address, and possibly other information, depending on where you open the account.
Coverdell ESA contributions can be invested in a wide range of investments, so the best course of action is to determine the type of investment that is appropriate for your needs, then find a broker, bank, or investment firm that can help you meet those needs. You will want to look at things such as:
Fees. You want to minimize investment transaction fees, custodial fees, annual fees, or other fees
Investment options. Do they offer mutual funds, index funds, stocks, bonds, CDs, etc.?
Other account features. Can you link your account to a savings account, or other account, etc.
The Coverdell ESA works much like a Roth IRA, and at one point was called the Education IRA. Contributions are non-deductible and grow tax free. Withdrawals are also tax free for qualified higher education expenses. Some examples of qualified expenses include tuition and fees, books, supplies and equipment, and in many cases, room and board.
One feature that sets it apart from the 529 plan is the ability to use it for qualified expenses at any education level, including kindergarten to high school and post-secondary (college level), provided the school is eligible to accept Coverdell funds.
Coverdell ESA eligibility
The beneficiary of the Coverdell ESA must be younger than 18 at the time the contribution is made and the assets must be used or transferred to another beneficiary by the time he or she turns 30. There is no limit to how many accounts can be opened per person, however, the total annual contributions to the recipient cannot exceed $2,000 per year from all sources.
ESA Contribution and income limits
To be able to contribute the maximum amount, contributors must have an AGI lower than $95,000 for single filers and $190,000 for joint filers. Contribution limits are phased out for AGI levels between $95,000 – $110,000 for single filers and $190,000 – $220,000 for joint filers. To avoid the income limits and make the full contributions, you can gift the money to the minor and they can contribute it to their own Coverdell ESA.
Coverdell ESA withdrawals
Coverdell ESA withdrawals can be used for qualified expenses for students attending K-12 and/or higher education. Withdrawals are tax-free if used for qualified expenses, otherwise, the recipient may be required to pay early withdrawal penalties on the funds.
Use it, transfer it, or pay taxes
The money contributed to a Coverdell ESA is for educational use only, and you cannot withdraw your contributions for personal use (which differs from the 529 College Savings Plan). If the beneficiary does not use the assets in the Coverdell ESA by the time they turn 30, then there are two options for the money:
Assets are automatically distributed and will be subject to taxes and penalties.
Assets can be transferred to another relative.
Coverdell ESA accounts offer tax benefits but have some limitations
ESAs offer great tax benefits for college savings but they are somewhat more restrictive than the 529 College Savings Plan. The biggest downsides are the $2,000 per year maximum contribution and the requirement to use the assets by age 30.