Saving For College With A Coverdell Education Savings Account

By Mark Di Vincenzo. May 7th 2016

Coverdell Education Savings Accounts, once known as Education IRAs, are trusts created to help pay for qualified education expenses.

Most people create Coverdells to help pay for college tuition and fees, but it’s not widely known that they also can be used to pay for elementary and secondary school expenses.

In this article, we’ll cover the basics about the Coverdell to help you determine if you want to use one to help pay for future education expenses.

What’s The Origin Of The Coverdell ESA?

It was established by the Taxpayer Relief Act of 1997 and then expanded by the Economic Growth and Tax Relief Reconciliation Act of 2001.

How Does It Work?

A lot like a Roth IRA. Both allow you to make an annual non-deductible contribution to an investment trust account. The money grows free of federal income taxes, and if all goes as planned, withdrawals from the account will be completely tax-free as well. Of course, the big difference is the Roth is for retirement and the Coverdell is for education. (To learn more about Roth IRAs, see Differences Between Roth And Traditional IRAs.)

How Much Can I Contribute Per Year To A Coverdell And How Long Can I Make The Contributions?

You can make a maximum contribution of $2,000 per beneficiary until the student reaches age 18. (There are no age limits for students with special needs.) The contribution limit was raised from $500 in 2002, the same year that K-12 expenses were allowed to be covered.

$2,000 Is Better Than $500, But It’s Still Not A Lot.

That’s right. The low limit means your overall investment return can be affected by even a small annual fee charged by the institution that holds your Coverdell. So be sure to ask about fees before you open an account.

Who Owns Coverdell Accounts?

The student or the student's parent can have account ownership.

How Long Do I Have To Use The Money?

Until the student reaches age 30. Any earnings not used by then will be taxed as ordinary income. The account owner will also face a 10 percent penalty on the funds.

Are There Any Ways Around The Taxation And Penalty?

Yes. You can roll one Coverdell account over to the Coverdell account of a family member of the student who didn’t use the money.

Is There An Income Limit?

Yes. If you earn more than $110,000 for a single filer or more than $220,000 for a couple filing jointly, you can’t open an account.

Is There Any Way Around The Income Limit?

Yes. You can make monetary gifts to the student and have the student make the contributions. But if you do, it counts as an asset and will make it harder for the student to receive need-based financial aid. If the parent makes the contributions, it has practically no impact on financial aid. Another way around the income limit is to have a company, including a tax-exempt organization, contribute to someone’s account. It doesn’t matter if the company is Apple or Joe’s Junk Shop.

Tell Me More About The Tax Advantages.

Contributions to a Coverdell aren’t deductible for federal or state income taxes, but earnings in the account accumulate tax-free. Qualified distributions are exempt from federal income tax. But if you withdraw money and don’t use if for qualified expenses, it is taxed at the donor’s marginal tax rate, plus a 10 percent penalty. The exception is if the student dies or becomes disabled. In those cases, non-qualified distributions remain tax free.

What Is A Qualified Expense?

Elementary, secondary and college expenses, including tuition, fees, tutoring, books, supplies, related equipment, room and board, uniforms, transportation and computers.

Can I Contribute To A Coverdell And A 529 College Savings Account In The Same Year?

Sure, but make sure you don’t exceed $13,000 or you could face unpleasant gift tax implications. (To learn more about the gift tax, see The Rules Of The IRS Gift Tax.)

Can I Claim Education Tax Credits And Withdraw Money From A Coverdell In The Same Year?

Yes, but the tax credits must be used to pay for different qualified expenses than the Coverdell.(For more information on education tax credits, see 4 Tax Breaks For College Education Expenses.)

What’s The Biggest Downside To A Coverdell?

Well, that’s debatable, but if the student doesn’t use the money for qualified education expenses, the money is eventually distributed to the student, unlike a 529 plan, which returns the money to the parents or contributors. Some don’t like that the Coverdell must be used by age 30 or it is subject to taxes and penalties. And coordinating withdrawals with other tax benefits, especially the Hope or Lifetime Learning credits, can be tricky.

Anything Else To Worry About?

Well, yes. Unless Congress acts, certain education savings account benefits will expire after 2012. K-12 expenses will no longer qualify. The annual contribution limit will return to $500. And withdrawals will not be tax-free in any year in which a Hope credit or Lifetime credit or Lifetime Learning credit is claimed for the beneficiary.

Like just about any investment product, the Coverdell isn’t for every family. There are pros and cons, and you should have all of them explained to you by a financial adviser or other professional before making the decision to open an account.

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