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Coverdell Education Savings Account (ESA) review

Invest in your child’s college education and get some tax breaks.

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A Coverdell Education Savings Account (ESA) allows you to invest in a diversified portfolio to fund your child’s college education expenses. Contributions aren’t tax-deductible, but your earnings grow tax-free and you can make tax-free withdrawals to cover 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 to open one.

What is a Coverdell account?

Coverall ESAs are custodial or trust accounts designed to help families save for their children’s educational expenses while enjoying some tax breaks. When money goes into the account, it grows tax-free.

Withdrawals are also tax-free as long as you use them on the beneficiary’s qualified educational expenses for K-12 or college. According to the IRS, these are expenses required for attendance at an eligible institution. That covers most schools in the U.S.

For any single beneficiary, the annual contribution limit is $2,000. That is a total limit that applies to all Coverdell ESA accounts for a designated beneficiary, regardless of who contributes the money. Contributors must also meet certain income limits.

Eligibility requirements

To open a Coverdell ESA 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 ESA?
    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 ESA functions a bit like a retirement plan for your beneficiary’s educational expenses. Most financial institutions like banks and mutual fund companies 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.

  • Stocks
  • Bonds
  • Mutual funds
  • ETFs

In the account, your money grows from investment returns tax-free. And 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 higher education expenses (College)

Tax-free withdrawals can be used for:

  • Tuition
  • Textbooks
  • Supplies
  • Equipment
  • 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
  • Uniforms
  • Transportation
  • 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’d owe income taxes on the distribution. In addition, you’d 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’d 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 also an option. It offers a few more tax benefits than Coverdell ESAs and may be a bit more flexible for some people. Here are a few quick differences between the two.

529 Plans Coverdell ESAs
What are the annual contribution limits? Varies by state, but can range from $235,000 to more than $500,000. $2,000
What are the tax benefits?
  • Tax-deductible contributions
  • Earnings grow tax-free
  • Tax-free withdrawals for qualified education expenses
  • Tax-free earnings
  • Qualified tax-free withdrawals for qualified education expenses
Can I make tax-free withdrawals for K-12 expenses? Yes. Up to $10,000 can be withdrawn tax-free to cover tuition at eligible K-12 schools. Yes. You can make tax-free withdrawals on all qualified education expenses as defined by the IRS for Coverdell ESAs.
Are there income limits to invest in these accounts? No Yes
Who can open this account? Anyone who is at least 18 years old and has a valid Social Security or tax identification number. Anyone at least 18 years old, but the beneficiary must be younger than 18.

You don’t have to live in the same state that sponsors your 529 plan, and your beneficiary doesn’t even have to go to school in that state. So you have the flexibility to choose which one you want to open.

The tax benefits remain the same, but some states may have higher contribution limits or better investment options. But the qualified expenses can’t be more than what’s required for your beneficiary to enroll in school, regardless of the state sponsor’s contribution limit. The same goes for Coverdell ESAs.

Opening a 529 adviser-guided plan is another possibility. As with a Coverdell ESA, a 529 plan allows you to build a portfolio with various securities like stocks, bonds and mutual funds. But with 529 plans, you’re limited to what the sponsor or adviser chooses for the plan’s investment menu.

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 ESA 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.

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    Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.

    Bottom line

    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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