A Coverdell Education Savings Account: Fund Yours with Tax-Free Money

Updated on October 13, 2019 Updated on October 13, 2019
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If you have kids who may go to college someday, chances are that you have at least heard of a 529 College Savings Plan. But sometimes in the same breath, you may have also heard of something called a Coverdell Education Savings Account. What’s that all about?

What is a Coverdell ESA (Education Savings Account)?

History

In the late 1990s, there was a lot of legislation going around dealing with tax-free college savings. This was when the 529 Plan was created as well as something called an Education IRA.

The main difference was that the 529 Plan centered around higher education costs while Education IRAs also included primary and secondary education costs. Later the Education IRA was renamed the Coverdell Education Savings Account after Senator Paul Coverdell who pushed for it.

If it sounds like there could be a lot of overlap between the two plans, it means your ears are working right.

And like other similar but in-the-same-space things such as BetaMax vs. VHS (for you Gen x-ers) or DVDs vs. streaming (for those of you thinking, “Beta-wha?”) usually one takes over the market and the other collects dust in the basement.

Think of Coverdell ESAs like Beta or DVDs – not without merit, but niche at best.

With 529 Plans evolving to cover both K-12 and special needs, the need for Coverdell ESAs is getting smaller still. Add to this its added restrictions and you almost have to search for a reason to have one. But there are a few.

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How It Works

You often hear that a 529 Plan works like a Roth IRA for education. In fact, I said it myself in another article. But looking more closely, a 529 Plan works more like a Roth 401k and a Coverdell ESA like a Roth IRA.

The main differences between the two Roth account types are in investment choices, maximum contributions, and gross income limits. So it also is with 529s and Coverdells. While Roth IRAs often have a wider variety of investment choices than 401ks, they also have gross income limits and smaller contribution limits. It’s the same thing with Coverdell ESAs over 529s.

Like either type of Roth, you invest with after-tax money, and it grows tax-deferred. Then it’s all tax-free at the end, except instead of retirement you must use it for qualified education expenses.

Specifically for a Coverdell ESA, you can use it for any qualified expenses from elementary school through graduate school.

Since it’s highly likely that the main reason you’re here is because you want to know if a Coverdell ESA is worth getting over a 529 Plan, I’ll frame the rest of this article describing the features of Coverdell ESAs in contrast to 529 Plans.

As a college fund, a 529 Plan is like a Roth 401k and a Coverdell ESA more like a Roth IRA.

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Coverdell ESA Advantages

It Covers More Expenses

While a 529 Plan covers most college expenses as well as (due to the recent TCJA legislation) up to $10k annually for K-12 tuition and fees, a Coverdell ESA has no annual K-12 spending limit and also covers most K-12 expenses beyond just tuition and fees. This includes books, supplies, computers, and special needs services among other items.

More Investment Choices

Usually most 529 Plans have a limited number of investment choices available (e.g. diversified mutual funds, target-date funds, index funds).

This is because like how your 401k is run by your company, most 529 Plans are run by states. These states have agreements with one particular financial institution that offers a small menu of safer investment choices.

But because you usually open Coverdell ESAs at a brokerage, bank, or other independent financial institution, you will generally have access to the full slate of investment options at those commercial outlets, like with a Roth IRA.

Do you want to invest in Amazon with your kid’s college fund and let Jeff Bezos determine his or her future?  You can’t do that with a 529. But with your Coverdell? Go for it.

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Coverdell ESA Disadvantages

Gross Income Limit

I know… any limit to your income is gross, but that’s not what we mean here. To contribute the full amount to a Coverdell ESA, your modified adjusted gross income (MAGI) must be less than $195k for joint filers ($95k for single filers). 529 Plans have no income level limit to be able to contribute.

And if the only MAGI you know about is from the short story “The Gift of the Magi” by O. Henry, don’t worry too much about it. It’s a calculation based on (and likely very similar to) your adjusted gross income, which is a line on your tax form.

For now, think about it like your salary before taxes. And if the only O. Henry you know about is the candy bar, you can use your Coverdell ESA to take an American Literature class!

Hard Contribution Limit

Speaking of contributing to a Coverdell ESA, there is a set annual contribution limit of $2,000 from all sources to any single beneficiary. This is regardless of who or how many contributors there are. Any amounts above that are taxed at 6% each year that the excess remains in the account.

This means that if mom and dad contribute $1,500 one year and in that same year your generous mother-in-law contributes $1,000 (even in a separate Coverdell that she tacitly opened up on behalf of your child), the recipient is responsible for paying a 6% tax on the extra $500 until it’s withdrawn.

With 529 Plans the only limit to your contribution is based on gift taxing limits ($15k for 2019) and lifetime gift exclusion limit (in the millions). In other words, limitless unless you decide to go to a very expensive school… that must give out diamond-encrusted diplomas.

No State Tax Deduction

With most state-sponsored 529 Plans your contribution is state tax-deductible. There are no pre-tax state tax benefits with a Coverdell ESA.

Age Restrictions

You can only contribute to a Coverdell ESA for the benefit of someone who is under 18. Once they hit that magic age, all contributions must stop. If not, again, taxes are due annually on any amounts contributed after 18. But that’s only until the age of 30 because…

At 30 all of the funds must be spent or the gains will be subject to ordinary income taxes plus a 10% penalty for your thriftiness.

One way you can avoid this is to take advantage of the fact that there is no tax or penalty for changing the beneficiary of the Coverdell ESA to another family member. Also, none of the age restrictions apply to a special needs beneficiary.

With a 529 Plan, there is no age limit for contributions nor deadline to spend. This also applies to 529 ABLE plans, which are 529-like plans for those with special needs.

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Getting the Most Out of Coverdell ESAs

Some people still rent DVDs or check them out at the library. Some do it because it’s cheaper than streaming services or they like the special features. Likewise, there are going to be people who may find good uses for a Coverdell ESA.

If You Have High K-12 Expenses

For parents of children in private K-12 schools, a Coverdell ESA can be a good option since you can use it for much more than just tuition and amounts greater than $10k per child. Again, Coverdell ESA distributions can be used for things like books, uniforms, and even room and board for boarding schools.

If you also want to take advantage of the possible state tax deduction that goes with contributions to a 529, you can have both.

There is no restriction on having both a 529 and Coverdell ESA. You can use the 529 for the tuition and fees up to the $10k and the Coverdell ESA for everything else.

Then once your child finishes high school, you can do one of two things. You can rollover the remaining Coverdell ESA balance to the 529 for the same beneficiary or transfer it to another family member’s Coverdell ESA.

If You Want Specific Investment Options

The fact that any investment you can buy in an IRA is usually available in a Coverdell ESA may be appealing to some.

Perhaps you are very risk-tolerant and have a short time to potentially make a lot of gains for your college fund and want to risk it all on some hot stock. Or you may be extremely risk-averse and only want to buy government bonds with your college fund. You can do that with a Coverdell ESA.

Some Additional Tips and Notes

Getting Around the Income Limit
Earlier it was noted that with a Coverdell ESA, there is a gross income limit to contribute. You can get around this income limit by first gifting the contribution to your child and then having the child be the contributor to the Coverdell ESA.

Unlike a Roth IRA, the child does not have to have earned income to contribute.

Financial Aid Impact
With regards to financial aid, any amount you have in a Coverdell ESA owned by the parent or dependent child will impact any need-based financial aid the same way as a 529 Plan.

It is considered a family asset and only reduces aid by 5.64% of the value of the asset. This is the same as any checking or savings account.

Next Steps

So if you think you have a situation where a Coverdell is the right choice for you, you have some options to consider. Several brokerages and mutual fund companies offer Coverdell ESAs if you want to shop around for the best one.

You can also go through a broker like CollegeBacker and have them find a good one for you. If you want to someday rollover your Coverdell ESA to a 529, it may be easier if the institution you select does both.

Nathan Kim - Contributor Nathan Kim is a contributor to Listen Money Matters. Learning from past mistakes, he spent the next twenty years educating himself on personal finance. He's logged hundreds of hours helping people improve their financial situation. Nathan has a Bachelor's Degree in Electrical Engineering and a Certificate in Economics from Georgia Tech, where he was a member of the economics honor society Omicron Delta Epsilon.
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