What is a Coverdell ESA?
A Coverdell education savings account is a tax-advantaged trust or custodial account used to save for educational expenses. Contributions to Coverdell accounts can total up to $2,000 a year and are tax deferred, meaning any growth in the account would not be subject to income or capital gains taxes when the beneficiary pulls money out, provided that it goes toward qualified educational expenses. And while saving for college is why many people use a Coverdell ESA, the account can also be used toward eligible K-12 expenses.
How a Coverdell ESA works
There are several rules and stipulations regarding who can open a Coverdell ESA and how much you’re able to contribute.
To open a Coverdell education savings account, you must meet certain criteria. The IRS’ stipulations include:
The designated beneficiary for the Coverdell must be under 18 years old. There can be exceptions to this rule if the beneficiary has special needs.
The account has to be defined as a Coverdell ESA on the day it is opened.
The documents used to open and establish the account have to be in writing.
You can have more than one Coverdell account for a beneficiary, but the total contribution to all accounts cannot exceed $2,000 per year. Similar to the rules concerning individual retirement accounts, you can make your annual contribution to an ESA up until the tax filing deadline for that year.
There are income limits on who can open a Coverdell account, and they depend on your modified adjusted growth income and filing status. If you file your taxes jointly and your MAGI is under $190,000 per year ($95,000 for single filers), you’re eligible to contribute the full amount. Those with a higher MAGI will see the amount they can contribute reduced. And if your MAGI is above $220,000 per year ($110,000 for single filers), you aren’t eligible to contribute to a Coverdell ESA.
Generally speaking, the beneficiary of a Coverdell ESA will be able to draw money from the account tax-free, as long as the money is put toward qualified educational expenses. The range of what qualifies is fairly broad: Funds can be used for tuition, books and supplies, tutoring, and in some cases transportation or room and board.
Nonqualified distributions are taxable to the beneficiary, along with a 10% penalty, so it’s important to understand whether an expense will be considered qualified before taking a distribution. If you’re unsure about whether a distribution meets the criteria, you may want to consult with a tax advisor to avoid making a costly error.
Any remaining funds in a Coverdell ESA must be distributed when the beneficiary of the account turns 30 (again, there are exceptions if the beneficiary has special needs). If the distribution at age 30 doesn’t qualify as an educational expense, the taxes and 10% penalty would apply to the beneficiary of the account. However, you are allowed once a year to change the beneficiary of a Coverdell account to another family member.
Coverdell ESA vs. 529 plans
If you don’t qualify to contribute to a Coverdell ESA, there are other ways to save toward education, including 529 plans. ESAs and 529 plans are similar in that contributions are considered tax-deferred. However, there are a few key differences between the two.
In order to open a Coverdell ESA, the beneficiary of the account must be under 18 at the time, and the funds must be distributed once the beneficiary turns 30.
Unlike ESAs, 529 plans don’t have age restrictions. The beneficiary of a 529 plan can be any age when the account is established, and there is no limit on when the funds can be used.
If you earn above a certain level of income, you may be ineligible to open or contribute to a Coverdell ESA. Higher earners looking for tax-deferred savings toward education might consider opening a 529 plan instead, as they don’t have an income restriction on contributions.
While Coverdell ESAs begin phasing down contribution limits for single filers with a modified adjusted gross income above $95,000 (or $190,000 for joint filers) and are unavailable to those with a MAGI above $110,000 (or $220,000), a 529 plan has no limit on annual contributions.
That said, with a 529, if you contribute more than $15,000 in one year per beneficiary ($30,000 for joint filers), you may be subject to gift taxes. With 529 plans, you are allowed to front-load contributions for up to five years without triggering a gift tax, meaning you could contribute $75,000 ($150,000 for joint filers) at one time, but any additional contributions toward the same beneficiary over the next five years would be subject to gift taxes.
There is no limit on withdrawals from 529 plans used for qualified college expenses. However, you are limited to $10,000 per year of withdrawals for qualifying K-12 expenses. Coverdell ESAs do not have any limits or restrictions for educational expenses at elementary or secondary schools.
In 2019, the SECURE Act expanded the regulations on 529 plans so that you can now also take out up to $10,000 per year to repay student loans.
Generally, 529 plans have a limited selection of funds to invest in. If you open a 529 through a broker, you may also pay management fees, which can hinder your returns over time. Each state has its own 529 plan rules and regulations, so you might consult with a local financial advisor to make sure you understand what’s available in your state.
Coverdell ESAs often have more investments to choose from. Whereas a state’s 529 may offer a limited selection of funds, Coverdell ESAs can allow for self-directed investments into stocks, mutual funds or exchange-traded funds.
Is a Coverdell ESA right for me?
Depending on your financial situation, opening a Coverdell ESA might be a great fit for you and your family. If you’re looking for tax-deferred savings toward education with more flexibility regarding your investment choices, then a Coverdell might make sense for you.
If you’d like to contribute more than $2,000 per year toward educational savings, you might consider opening a 529 plan instead, or in addition to a Coverdell. As always, it’s best to consult with your tax professional or financial advisor before making a selection on the best fit for you.