We won’t bore you with yet another rundown of how expensive college has become. You know. We know you know. And you know we know you know.
What you might not know, however, is just how many tools are available to help you prepare and save for your child’s expensive college costs.
Today, we’ll introduce you to one such tool that often flies under the radar: the Coverdell education savings account (ESA).
The Tea
The Coverdell ESA is an investment account with a few special advantages that makes it easier and more cost-efficient to pay for education expenses.
WealthUp Tip: If you’re weighing using a 529 or a Roth IRA to save for your child’s college costs, check out our guide.
Coverdells are similar to custodial accounts. An adult opens an account for a minor. Contributions can be invested to help the money grow over time. The minor is the beneficiary and technically owns any funds in the account, but the adult makes investment and withdrawal decisions until the child reaches the age of majority in their state, typically 18.
However, unlike with custodial accounts, money in a Coverdell must be used for qualified educational expenses.
The Take
The Coverdell ESA is certainly a useful tool for educational savers, but it does have its limitations—and those limits define both who can put Coverdells to use, and how best these accounts can be used. So let’s dive into the nitty-gritty of ESAs to better understand their strengths and weaknesses.
Who Can Open an Account and Contribute?
Coverdells allow a wide range of people to open an account. That is, they’re not limited to parents—grandparents, uncles, family friends, really any adult can open a Coverdell ESA for a child.
But there are income limitations. Specifically, you can only contribute up to the full annual limit (currently $2,000) if your modified adjusted gross income is less than $95,000 (single) or less than $190,000 (married filing jointly). Above those thresholds, the amount you can contribute phases out. Once you reach $110,000 (single) or $220,000 (married filing jointly), you cannot contribute at all to a Coverdell.
Contributions to an account must be made before the beneficiary is 18 years old. (There are no age limits for special-needs beneficiaries.)
Tax Consequences
Contributions to a Coverdell are made on an after-tax basis, much like a Roth IRA. From there, account holders enjoy a decent tax benefit:
WealthUp Tip: If a 529 you opened has unused funds, here’s what you can do with them.
“From a tax-advantaged perspective, contributions to the account are not tax-deductible, but the earnings grow tax-free,” says Miles McQuillen, Assistant Vice President on the Private Wealth Management team at Gabelli Funds, a diversified global financial services firm. “To that end, withdrawals used for qualified educational expenses … are also tax-free. Therefore, the potential tax-efficient growth can significantly enhance the value of your savings, especially over a long period of time.”
Impact on Financial Aid
A Coverdell ESA affects financial aid, but minimally. A Coverdell ESA is usually owned by the parent. Thus, only 5.64% of ESA assets are taken into account when calculating the Student Aid Index (SAI).
Investment Options
The investment options available within a Coverdell ESA vary depending on who you open an account with. Some providers offer extremely limited options—sometimes requiring you to invest in a single mutual fund. However, other providers are fully self-directed, providing selections of stocks, exchange-traded funds (ETFs), and mutual funds that are similar to what you’d find in a brokerage account or individual retirement account (IRA).
WealthUp Tip: Starting to save for your newborn? Here are the best college funds to consider.
Covered Expenses
Speaking of which, Coverdells boast the widest range of qualified educational expenses.
“A main selling point of this plan is the flexible use of funds,” McQuillen says. “Unlike some other education savings vehicles, the Coverdell ESA offers flexibility in how the funds can be used.”
You can spend Coverdell funds not just on tuition at K-12 schools and college, but related expenses as well. That includes books, supplies, computers, computer software, room and board, and more.
Additional Considerations
Funds in the account must be distributed by the time the beneficiary reaches age 30. (Again, no age limits for a special needs beneficiary.) Before age 30, the beneficiary can be changed to another family member younger than 30 without consequence. However, if the beneficiary goes unchanged, when the beneficiary turns 30, any unspent funds are subject to both regular taxation and a 10% penalty on account growth.
WealthUp Tip: Not sure how much to save for your child’s college costs? We can help.
When Does a Coverdell Make the Most Sense?
While a Coverdell is a strong savings tool, it often plays second fiddle to the 529 plan, which has a number of advantages:
- 529s offer the same tax benefits, but you can contribute much more:
- The federal government has no contribution limits on 529s.
- Many states have maximum contribution limits for a single beneficiary, but they’re often set at the cost of a four-year college and grad school at an expensive institution within that state. In other words, these maximums are in the hundreds of thousands of dollars.
- Contributions are subject to annual ($18,000) and lifetime ($13.61 million) gift tax exclusion limits. However, 529s allow for a one-time “five-year gift-tax averaging.” You can combine five years’ worth of contributions into one lump-sum contribution (so, $90,000), but only $18,000 will count against your annual gift-tax exclusion each year. Couples can enjoy double the benefit; so, a $180,000 lump-sum contribution.
- 529s have no income restrictions governing who can contribute.
- 529s have no age restrictions on beneficiaries.
- Some states allow you to deduct 529 contributions.
- A beneficiary can roll over up to $35,000 of leftover money in a 529 plan into a Roth IRA in the beneficiary’s name. (Note: Any rollover is subject to annual IRA contribution limits, and the 529 account must have been open for at least 15 years.)
In fact, Coverdells really only have two distinct advantages over 529s:
- 529s are virtually always managed plans with limited investment options. Some Coverdell ESAs, however, can be self-directed.
- Coverdell money can be used toward both tuition and related expenses for both college and K-12. While 529 money can be used toward college tuition and related expenses, it can only be used for K-12 tuition, but not K-12 related expenses. Also, distributions for K-12 tuition are limited to $10,000 per year.
Given 529s’ other benefits, it’s unlikely that investment selection will sway many investors—while it’s nice to have options, 529s’ investment offerings are usually adequate.
The K-12 limitations might sway some savers, however. The flexibility in both distribution amount and qualified expenses could be helpful to families in certain situations.
So, getting back to the original question: When does a Coverdell ESA make the most sense?
- If you fall within the Coverdell’s income limits, and think you’d only be able to contribute up to the Coverdell’s annual maximum of $2,000, it makes sense to use a Coverdell. (Especially if you’re concerned about non-tuition K-12 expenses.)
- If you fall within the Coverdell’s income limits, and think you’d be able to contribute more than the Coverdell’s annual maximum of $2,000, it makes sense to use a Coverdell in conjunction with a 529 or another savings plan. (Especially if you’re concerned about non-tuition K-12 expenses.)
- And, of course, if you don’t fall within the Coverdell’s income limits, well … the Coverdell simply won’t be an option.
Riley & Kyle
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