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A Coverdell education savings account (ESA) is a tax-advantaged trust account you can use to save for your child's educational expenses. Compared to a 529 plan, a Coverdell ESA offers more flexibility with your investment options and eligible expenses. However, annual contribution limits make it less appealing for many parents. Here's what you need to know.
What Is a Coverdell Account?
A Coverdell ESA is designed for parents to save for a child's qualified educational expenses, including both K-12 and college costs. After you set up a Coverdell ESA, you'll be able to invest the funds on behalf of your child.
Financial institutions offer a wide variety of self-directed investment options for Coverdell ESAs, including individual stocks, bonds, mutual funds, exchange-traded funds and even real estate. In contrast, 529 plans typically offer portfolios based on your child's expected enrollment date or your preferred allocations.
Neither your contributions nor your earnings in the account are taxable if the funds you withdraw are earmarked for qualified educational expenses. However, contributions to a Coverdell ESA don't qualify for federal or state tax deductions or credits.
What Are the Requirements for a Coverdell ESA?
To open a Coverdell ESA, your chosen beneficiary must be under the age of 18 or have special needs. However, the IRS does not specify that the beneficiary must be your child. You also need to meet certain income requirements to be able to make contributions to the account—more on that in a minute.
The beneficiary must use the account's funds within 30 days after they reach the age of 30 unless they're a special needs beneficiary. Additionally, if the beneficiary dies, the funds must be distributed within 30 days of their death.
If you're worried about a tax bill from distributed funds, you can change the beneficiary on the account to one of the beneficiary's family members who's under the age of 30 or has special needs.
What Are the Contribution Limits for a Coverdell ESA?
A beneficiary can receive up to $2,000 in contributions each year, regardless of how many people are contributing or how many Coverdell ESAs have been set up for them. In contrast, 529 plans allow total contributions of up to nearly $550,000—there are no annual limits—depending on where you live.
However, your contribution limit may be lower depending on your income level.
In particular, if your modified adjusted gross income (MAGI) is less than $95,000 (or $190,000 if you're married and filing a joint tax return), you can contribute up to the $2,000 maximum. If your MAGI exceeds that threshold, your limit will be gradually reduced up to a certain point. If your MAGI exceeds $110,000 (or $220,000 if you're married filing jointly), you're ineligible to contribute to a Coverdell ESA.
Note, too, that you cannot continue to make contributions to the account after the beneficiary reaches age 18 unless they have special needs. If you make excess contributions to a Coverdell ESA, they'll be subject to a 6% excise tax for each year in which they remain in the account.
What Can You Use a Coverdell ESA For?
Eligible educational expenses for a Coverdell ESA include a variety of college and K-12 costs. Though there are some limitations—for example, some expenses must be required by your school or, if your child is in college, be incurred while they're enrolled at least half time—here are some general examples:
- Tuition and fees
- Room and board
- Books, supplies and equipment
- Computers, software and internet access
- Special needs services (if applicable)
Additional eligible K-12 expenses include:
- Tutoring
- Uniforms
- Transportation
- Supplementary items and services (such as an extended day program)
A 529 plan includes the same expenses for college students, but it also includes up to $10,000 in student loan payments. However, K-12 expenses are limited to tuition only, and there's a $10,000 limit.
Tax Consequences for Non-Qualified Withdrawals
If you withdraw funds for non-qualified expenses, the earnings portion of your withdrawal may be subject to income taxes and a 10% penalty. However, that additional penalty doesn't apply to non-qualified withdrawals to the extent that the account's beneficiary receives a tax-free scholarship.
For example, if your child's total qualified educational expenses for a semester equal $8,000, and they receive a $6,000 scholarship for the term, they can withdraw up to $2,000 from the account tax-free. If they withdraw more during that semester, the earnings portion of the withdrawal will be subject to income taxes but not the 10% penalty.
Keep in mind, though, that you can't double dip with other education tax benefits. So, if you also take distributions from a 529 plan or you or your parents qualify for the American Opportunity Tax Credit or Lifetime Learning Credit, those tax breaks can reduce the amount you can withdraw from your Coverdell ESA without incurring a tax bill.
How to Set Up a Coverdell ESA
Anyone can open a Coverdell ESA through a brokerage firm, bank or another financial institution that offers them. Here's how to do it:
- Compare your options. Research and compare accounts with several providers. In addition to investment options, you'll also want to compare fees and minimum initial investments.
- Apply for an account. You'll typically need to provide some information about yourself, as well as the full name, date of birth, Social Security number and address of your beneficiary. Then, submit your information to open the account.
- Decide how to contribute. Once you open the account, link your bank account so you can make contributions. Then, decide whether to make recurring or manual contributions going forward. Just be sure to remember the contribution limits, especially if your income is close to the IRS limit.
Alternatives to a Coverdell ESA
A Coverdell ESA provides a lot of flexibility in how you can invest your contributions and use them on a tax-free basis. But if the annual contribution limit is too low for your taste or your income exceeds the IRS limit, here are some alternatives to consider:
- 529 plan: A 529 plan may not offer as much flexibility with investment options or eligible expenses, but you'll get a much higher contribution limit. Additionally, some states offer a tax deduction or credit on your contributions.
- Roth individual retirement account (IRA): A Roth IRA is technically designed for retirement savings, but you can withdraw your contributions without incurring a tax bill. You can also withdraw earnings for qualified educational expenses without getting slapped with a 10% early withdrawal penalty—though you'll still incur regular income taxes.
- Brokerage account: If you want maximum flexibility with your investment options and how you can use the money, consider a brokerage account. In particular, you don't have to worry about incurring a 10% penalty for certain withdrawals. However, brokerage accounts don't offer any tax benefits for qualified educational expenses, so it may be a better fit if you expect your child to receive scholarships or you're unsure whether they'll even attend college.
- High-yield savings account: A high-yield savings account offers a safe, guaranteed return on your money. However, you won't get any tax breaks and it may not offer as high a return as you could earn using a 529 or other investment account. Consider this option if your child expects to attend college in the next few years and you don't want to deal with the risk of an investment portfolio.
The Bottom Line
Regardless of how you decide to save for college, it's important to consider your situation and goals. While a Coverdell ESA offers some unique benefits you can't get with other college savings plans, it also has some limitations.
If you're unsure how to proceed, consider consulting with a financial advisor who can provide personalized guidance and help you make the right decision for you and your family.