Coverdell Education Savings Accounts

Unlike Section 529 Plans that we discussed last week, Coverdell Education Savings Accounts’ (ESAs) disadvantages can potential outweigh the advantages for many people. However, Coverdells can still be very useful education savings vehicles if used correctly.

 

As we stated last week, keep in mind we are not discussing all of the information available on Coverdell ESAs, so make sure you do your own research before deciding which plan to invest in. Also, be sure you understand all the distributions rules as well.

 

Advantages

Many of the advantages of a Coverdell ESA are the same as a 529 plan. Those advantages are listed first. The last two bullet points are unique to Coverdell ESAs.

  • The beneficiary of Coverdell ESAs can be changed to a relative of the original beneficiary without any tax consequence. So, if the original beneficiary doesn’t need any of the money or doesn’t use all the money available in the account, then the beneficiary can be changed to a relative (just be sure to research who qualifies before you make a change). Also, there is an age restriction on the account—check out the first bullet point in the Disadvantages section.
  • There are tax advantages to using Coverdell ESAs for education savings. When the money in a Coverdell is distributed to be used toward qualifying educational expenses, the distributions are completely tax free. Also, since Coverdell ESAs’ contributions are after-tax, you can withdraw your original contributions without being taxed again, no matter the reason.
  • Coverdell ESAs are counted as an asset of the owner of the plan, not the beneficiary, in the calculation for federal financial aid. So, if you are the plan owner of your child’s account and you are also seeking federal financial aid, the funds will only be counted for 5.6% as the parents’ assets, instead of 35% as the student’s assets.
  • Coverdell ESA funds can be used toward primary, secondary, and postsecondary education. So, if you know that you would like to send your child to a private primary or secondary school, a Coverdell ESA can be a very useful tool for you (just be sure to check first if the school is eligible). Not only can the funds be distributed for tuition, but it can be used for a number of other expenses as well (tutoring, supplies, computers, required uniforms, etc). This account flexibility makes Coverdell ESAs a good choice for primary and secondary education funding, but many of the same rules (and institutions) apply to Coverdell ESAs as 529 plan when it comes to postsecondary schooling.
  • Coverdell ESA investments are flexible: you can choose where to open the account and what to invest it in (mutual funds, stocks, bonds, etc. – there are restrictions, make sure you know them before investing). This option allows you to do your own research to select what options will be right for your individual beneficiary and your own risk tolerance. However, it also puts the burden of responsibility on you if the investments do poorly (unlike 529 plans where you have no control over the quality of the investments)

 

Disadvantages

  • The money in the Coverdell must be used by the beneficiary’s 30th birthday. If there is money still in the account when the beneficiary reaches age 30, the total balance must either be distributed to the beneficiary, or the beneficiary must be changed to a relative of the original beneficiary who is also under the age of 30. If the funds are distributed, income tax and a 10% penalty will be charge on the earnings from the account (also done with distributions not used for qualified education expenses).
  • Coverdell ESAs have a contribution limit of $2,000 annually per beneficiary (not per account). Not only is there a limit, there is also tax consequences for going over the limit, so always be sure who is contributing to the account and how much. So, Coverdell’s are not useful for late savers hoping to play catch up quickly.
  • Contributions to Coverdell ESAs must end when the beneficiary reaches age 18. This can also be a negative for late savers or anyone who doesn’t plan on the beneficiary starting higher education immediately after graduating from high school. Also, this makes Coverdell ESAs unavailable to any adult looking to fund a return to school.

 

We believe Coverdell ESA are most useful in primary and secondary education, however, they can also be used in conjunction with another type of savings vehicle (like a 529 plan) for post secondary education. Due to its contributions limits, it’s not likely that you would be able to save enough for your child’s entire postsecondary education in a Coverdell ESA (if that’s your goal).

 

Next week we’ll discuss Roth IRAs and their advantages and disadvantages in saving for education.

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