As a parent, you’re accustomed to shelling out money for clothes, food, shoes — all the things kids need.
You might also know you need to carve out room in your budget to start saving for college. Many education savings guides say you should start saving “as early as possible.” But where do you plop your money?
You might want to consider a Coverdell Education Savings Account (ESA). Let’s go over the details of a Coverdell ESA and help you decide whether this type of account makes sense for you and your loved ones.
What is a Coverdell ESA?
You can think of a Coverdell Education Savings Account (ESA) as a savings account specifically for educational purposes. If you want the technical definition, a financial advisor would say that a Coverdell ESA refers to a trust or custodial account that pays for qualified education expenses.
Anyone (a parent, aunt, uncle or grandparent) can put money into an ESA for any beneficiary under the age of 18. Beneficiaries must use the money in the account by the time they turn 30 years old, though special needs beneficiaries don’t face any age restrictions. The money can go toward private kindergarten through 12th grade education expenses and qualified college expenses.
It’s important to understand the definition of “qualified” because this means the money in a Coverdell account can only go toward specific items. You can’t use it for, say, a new car battery when your car breaks down.
The following items fit into the category of “qualified” expenses:
Room and board
Fees (such as laboratory fees)
School supplies, such as notebooks and pencils
Equipment, such as a laptop
You can only contribute $2,000 per year to a Coverdell ESA as long as you have an income of less than $110,000 ($220,000 filing jointly).
How Does a Coverdell ESA Work?
Let’s take a look at the steps you can take to set up a Coverdell ESA until you take the money out as a withdrawal.
Step 1: Open an account.
You can open a Coverdell ESA at a bank, financial institution or brokerage firm. You must give the firm information about your beneficiary’s name, Social Security number and birthdate. You must always name the beneficiary for an ESA.
You can choose from a number of investment options for your account, including stocks, bonds, mutual funds, exchange-traded funds (ETFs) and more. You may want to reach out to a financial advisor or a guide to saving for a child’s education to determine the best investments for your beneficiary’s account.
In addition, don’t forget to check on the fees associated with opening a Coverdell ESA account.
Step 2: Understand the tax rules.
You can contribute money to a Coverdell ESA tax free and withdraw the money tax free when you use it to pay for qualified education expenses. However, contributions are not tax-deductible.
If you choose to use money you’ve contributed to a Coverdell ESA for non-qualified education expenses, it’s included in the gross income of the beneficiary and an additional 10 percent tax penalty may apply.
Step 3: Contribute money to the ESA.
You can contribute funds to a Coverdell ESA until a child turns 18. Kids can have more than one account — such as when a parent and grandparent contribute. However, the accounts combined cannot go over $2,000.
However, keep tabs on your income. Those married filing jointly who contribute the full $2,000 amount must have a modified adjusted gross income (MAGI) up to $190,000. The amount you can contribute will gradually reduce if you have a MAGI between $190,000 and $220,000. You cannot contribute if your income exceeds $220,000.
Single filers can contribute to a Coverdell account if their MAGI for the year amounts to less than $110,000.
You must contribute by your tax filing deadline, typically April 15, for the previous tax year.
Step 4: Withdraw the money when needed.
The final step involves withdrawing the money from your ESA when you need it. You can do this by completing and submitting a Coverdell ESA distribution request form from your bank, brokerage or other financial institution.
Once the money has been withdrawn, you can use it on qualified education expenses.
What happens if you leave lingering funds in your account? They become part of your beneficiary’s taxable income. If you want to keep this from happening, you can move the contents of the account to another beneficiary, but you must do this before your original beneficiary turns 30 years old.
What Are the Benefits of a Coverdell ESA?
The most obvious benefits of a Coverdell ESA include its tax benefits. Tax-free earnings growth and tax-free withdrawals make it an attractive option for those interested in saving for beneficiaries. In addition, it’s easy to roll the money to another beneficiary if necessary. In addition to the tax advantages, a few other benefits include:
You can choose from a wide variety of investment types.
It’s easy to change the beneficiary.
The FAFSA counts the Coverdell ESA as a parent asset.
However, it’s important to take a look at the downsides to a Coverdell ESA as well. You:
Can only contribute $2,000 per year.
Face income restrictions.
Cannot contribute after your beneficiary turns 18 and must close the account when your beneficiary turns 30 (unless your beneficiary has special needs).
It’s important to take a look at the pros and cons before you decide whether a Coverdell ESA works best for you. Otherwise, you can look into other college savings options, including the following: custodial plans, including the Uniform Transfer Gift to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA), through your own Roth IRA or from regular investment or savings accounts. You may also want to consider a 529 plan, which we cover in the next section.
Coverdell ESAs vs. 529 Plans
You may have heard of 529 plans, a popular choice for college savers. But what is the difference between ESAs vs. 529 plans?
First of all, state-run 529 plans, or tax-advantaged investment vehicles, can help you save for higher education expenses for a chosen beneficiary. They also often allow you to tap into state tax benefits.
Let’s take a look at the major differences between the two types of college savings plans:
No annual contribution limits with a 529 plan: A 529 plan doesn’t come with annual contribution limits like a Coverdell ESA, but you will have to pay attention to lifetime limits, which can vary from state to state and usually range from $200,000 to $400,000.
No income restrictions with a 529 plan: You’re not restricted from putting money into a 529 plan based on income level like you are with a Coverdell ESA.
Limited selection of investment choices with a 529 plan: A 529 plan may offer a limited selection of investment choices compared to a Coverdell ESA, which may offer more investment options.
No under-30 age requirement with a 529 plan: You won’t face the age requirement for a 529 plan like you will with a Coverdell ESA.
Five-year gift tax averaging with a 529 plan: 529 college savings plans allow five-year gift tax averaging, but Coverdell education savings accounts do not. This means that you and each other contributor can make a contribution of up to five times the annual gift tax exclusion in a lump sum. Couples filing taxes jointly can contribute two times this amount.
You can now use the funds in a 529 plan to repay student loans: You can repay student loans from a 529 plan up to $10,000 per borrower, but you cannot repay student loans with a Coverdell ESA.
As you read through these differences, you might decide that a 529 works better for your needs, but remember that it’s possible to become overeager and overfund your account. An ESA somewhat limits overfunding because you can only contribute $2,000 per year. It helps you calibrate saving in other areas of your life, including retirement.
Read More: 529 Plan vs. Roth IRA: Which is Better for College Savings?
Determine Whether an Education Savings Account Makes Sense for You
As you try to figure out how to pay for your kids’ college education, it’s important to consider several types of college savings plan investment options before you ultimately decide on the right one for you.
What’s right for your family may not necessarily be right for your next-door neighbor or best friend’s family.
You can track all of your financial accounts with Personal Capital’s free finance tools. Millions of parents use these tools to create savings goals, formulate budgets and plan for big-time long-term expenses like college tuition.
Be sure to use the Education Planner to better understand and compare college costs, and determine how much you need to set aside while you track your progress.
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Personal Capital compensates Melissa Brock (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.