What is a Coverdell ESA?
Coverdell Education Savings Account (ESA) is a tax-deferred trust or custodial account created by the US government to help families fund educational expenses for beneficiaries aged 18 or younger. The age restriction can be waived off for special needs beneficiaries. While it’s possible to establish more than one ESA for a single beneficiary, the annual maximum contribution for a single beneficiary is $2,000, and only families with income below a specific level are eligible.
Coverdell ESA offers tax-free investments and tax-free withdrawals to spend on qualified education expenses, including college expenses and certain K-12 purchases. Qualified elementary and secondary education expenses include books, supplies, equipment, and academic tutoring, among others.
Benefits of Coverdell ESAs
In 2002, the Education IRA was renamed to Coverdell Education Savings Account. This savings account has become an attractive tool for many people to save for their children’s college expenses. Elementary and secondary school expenses and certain K-12 expenses are included in the list of qualified costs. The key benefit of a Coverdell ESA is that it allows tax-deferred growth of its assets and tax-free distributions for qualified educational expenses.
Unlike 529 plans, ESAs allow you to self-direct investments with a choice to invest in CDs, bonds, stocks, and mutual funds that you believe have a great growth potential over the life of the investment. However, 529 plans allow you to select from only the investment options offered by the program manager.
Limitations of a Coverdell ESA plan
There are certain limitations and restrictions to the Coverdell ESA plan:
- Contribution limit and age limit: You are limited to a $2,000 contribution per year, and you are allowed to contribute only until your child reaches 18 years. This means the maximum you can contribute to an ESA is $36,000. With the rising cost of education, $36,000, plus the compounded earnings, may not be enough to pay for your child’s education expenses. And even if you have multiple ESAs, your total maximum contribution limit still remains $2000. If you exceed that limit, a penalty will be imposed.
- Low returns: A low contribution limit means low returns over time, and the custodian fee further reduces this amount.
- Income limit: Like Roth IRAs, there is a maximum income restriction to be eligible to fund an ESA.
- Less flexibility: There is always a possibility of your child starting their own business or using other ways to pay for their education expenses. In such a case, if the fund in ESA is not used for qualified education expenses, your child will be required to pay 10% penalty tax on the earnings, plus tax, unless the assets are transferred to a qualified family member who can use it for education.
- Less control: The fund in ESA, if not used for qualified educational expenses, goes back to the child and not to the parent, thus providing lesser control of the situation.
How do Coverdell ESAs work?
An ESA plan is similar to a self-directed IRA in that both allow you to make an annual non-deductible contribution to a designated investment trust account. The money in your account grows tax-free, and withdrawals are also tax-free. However, there are certain requirements you need to meet to make qualified contributions and withdrawals.
Coverdell ESA Eligibility and Income Limits
Here are the several Coverdell ESA rules and stipulations that govern an ESA:
In order to open an ESA, you need to meet these eligibility criteria:
- The designated beneficiary must be under 18 years old. This age limit is waived off if the beneficiary has special needs.
- All the documents required for opening this account have to be in writing.
- The account has to be defined as a Coverdell ESA on the day it is opened.
You can have multiple Coverdell ESAs, but the total annual contributions cannot exceed $2000. Your eligibility to open a Coverdell account depends on your modified adjusted growth income (MAGI) and filing status.
- You are eligible to contribute a full $2000 to an ESA if your MAGI is under $190,000 (for joint filers) and $95000 (single filer).
- Your contribution amount is reduced if your MAGI is higher than $190,000 and less than $220,000.
- You cannot contribute to an ESA plan if your MAGI is more than $220,000.
Coverdell Education Savings Account Withdrawals
If the fund in the ESA is used for qualified educational purchases, such as transportation, tuition fees, books, room rent, and equipment, your distributions are tax-free. Some Coverdell ESA withdrawal rules include:
- Non-eligible withdrawals attract a 10% penalty plus taxes.
- Unused amount, if left in the account even after the beneficiary turns 30, will be considered as taxable income, and the beneficiary will incur a 10% penalty.
- You can change the beneficiary of a Coverdell account to another family member once a year.
If you are looking for tax-deferred savings for your child’s educational expenses and more flexibility in terms of investment choices, then a Coverdell ESA might be the right choice for you. However, it is always best to consult a financial expert to decide if Coverdell ESA is perfect for your financial situation.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.