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Coverdell Education Savings Account (ESA): Is it right for you?
Invest in your child’s college education and get some tax breaks.
A Coverdell Education Savings Account (ESA) allows you to invest in a diversified portfolio to fund your child’s primary or secondary schools (grades K-12), or college expenses. Contributions are tax-deductible, but distributions are tax-free as long as you use them for qualified education expenses. However, contribution limits are small compared to other college savings vehicles, and you have to meet certain income limits to be eligible for an ESA.
What is a Coverdell Education Savings Account?
Coverdell ESAs are custodial or trust accounts designed to help families save for their children’s educational expenses. Aside from individuals, corporations and trusts can also make contributions to an ESA.
You can contribute maximum of $2,000 each year, but this depends on your income. Corporations and trusts can contribute the full $2,000 without income restrictions.
Once funded, you can use your Coverdell to cover expenses such as books, supplies, equipment, academic tutoring and special needs services. Eligble expenses are tax-free but if the distributions are higher than the expenses, the gains are taxed at the account holder’s rate. There’s no restriction on the amount of qualified funds distributed within a year.
To open a Coverdell Education Savings Account, you and your beneficiary must meet certain eligibility requirements. You also have to follow some rules.
- For whom can I open a Coverdell ESA account?
Your beneficiary can be anyone under the age of 18 or any special needs individual. This individual doesn’t have to be a family member.
- Where can I open a Coverdell Education Savings Account?
Most financial institutions such as banks and investment management firms.
- What are the income limits for opening a Coverdell ESA and making the maximum contribution?
- A modified adjusted gross income (MAGI) of less than $110,000 for single filers.
- A MAGI of less than $220,000 for joint filers.
- Is there a phase-out for income limits?
Yes, your eligibility to make a full contribution reduces when your MAGI falls between $95,000 and $110,000 (between $190,000 and $220,000 if filing a joint return). In other words, you can’t make the full annual $2,000 contribution if your income falls in those ranges. Your contribution limit would be reduced.
- Can I make contributions indefinitely?
No, you can’t make contributions to a Coverdell ESA once the beneficiary turns 18.
How does a Coverdell account work?
A Coverdell Education Savings Account functions a bit like a retirement plan for your beneficiary’s educational expenses. Most financial institutions like banks or brokers will open one for you if you’re eligible. After filling out some paperwork, you can start investing.
A typical Coverdell ESA can invest in various securities as long as they’re allowed by the financial institution holding your account and they comply with IRS law. Here are some common investment options.
- Mutual fund
In the account, your money grows from investment returns with deferred tax. Tax-free withdrawals are possible as long as they cover qualified educational expenses as defined by the IRS. Generally, these are expenses directly required for attendance.
Qualified education expenses
Tax-free withdrawals can be used for:
- Special needs services in connection with enrollment
- Internet access, computers and computer equipment required for enrollment and educational purposes
For room and board to be considered a qualified expense, the student must be enrolled at least half-time. The price tag also has to be greater than one of the following amounts:
- The allowance for room and board, as determined by the school for a particular academic period and living arrangement.
- The actual amount charged if the student is living in housing owned or operated by the school.
For K-12 programs, a qualified educational expense is generally the same as for college. However, the IRS adds the following.
- Academic tutoring
- Room and board
- Supplementary items and services, including extended day programs
Keep in mind these must be required for enrollment to qualify as education expenses. Plus, all funds in a Coverdell ESA must be used by the time the beneficiary reaches age 30 to avoid fees and penalties.
Coverdell ESA: What to watch out for
The IRS looks at any nonqualified withdrawal as taxable income. Therefore, you’ll owe income taxes on the distribution. In addition, you’ll face a 10% penalty tax.
However, tax-free withdrawals are permitted as long as they cover qualified educational expenses and the withdrawal doesn’t exceed these expenses. If your child’s tuition costs $30,000 and you withdraw $35,000, you’ll owe income taxes on the additional $5,000.
You may also face taxes if you exceed the Coverdell ESA contribution limits. The IRS charges a 6% excise tax on the amount in a given tax year that exceeds $2,000.
Furthermore, be cautious if taking an American opportunity or lifetime learning credit. According to the IRS, “the beneficiary must reduce qualified higher education expenses by tax-free educational assistance, and then further reduce them by any expenses taken into account in determining an American opportunity or lifetime learning credit.”
In other words, you can’t take two tax breaks for the same benefit. When using a Coverdell ESA and an American opportunity or lifetime learning credit, part of the Coverdell ESA withdrawal may become taxable even if used on qualified higher education expenses. So you may want to speak to an accountant if you and your child choose this route.
Coverdell vs. 529 accounts
A Coverdell ESA isn’t your only choice when it comes to saving for college — a 529 college savings plan is another option. It offers a few more tax benefits than Coverdell ESAs and may be a bit more flexible for some people.
For example, an ESA has a maximum annual contribution of $2,000, while the 529 plan maximum contribution can range from $235,000 to more than $500,000. Also, there are no income limits for the 529.
How to choose a Coverdell account
Most financial institutions like banks and investment management firms will set you up with a Coverdell ESA. So if you already work with one, you may want to start there.
But shop around as Coverdell ESA fees and features can vary across institutions. Keep an eye for the following:
- Minimum deposits to open an account
- Management fees and other expenses
- Investment options
Compare interest-earning accounts
If you think neither a Coverdell Education Savings Account or 529 plan is right for you, you may want to consider opening a basic investment account. While the tax benefits may not be as generous, you may see fewer restrictions and more flexibility. In some cases, you may have more investment options and the opportunity to work with a financial adviser or hand off investment management to a sophisticated robo-advisor algorithm.
A simple savings account may be the safest bet, but you’d likely earn the smallest amount of interest.
Coverdell ESAs can be great college savings platforms. They provide tax benefits and the opportunity to invest in various asset classes.
But they also have contribution limits and income caps. So explore options like 529 plans and other ways to save for college before you make a decision.
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