Coverdell Education Savings Account

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If you're saving for college, then there are a couple of ways the federal government is willing to help out in the form of a tax break. One of them is the Coverdell Education Savings Account or Coverdell ESA. Some of you might remember the Coverdell when it was called an education IRA, but it's got a new name and some new rules too.

Coverdell ESA Rules

In fact, the "old" education IRA was woefully behind the times when it came to saving for college. Those IRAs offered the account holder the opportunity to set aside $500 each year - hardly enough money to make a dent in today's college tuition expenses.

Additional Resources

Today's Coverdell education savings account not only carries a different name, but the rules have been updated too. Using a very high level description, a Coverdell ESA is a custodial account that can be used to pay for qualified education expenses of the beneficiary of the account. Now let's dig a bit deeper into the Coverdell ESA rules with respect to account contributions and taxes.

Coverdell ESA Contribution Rules

If your modified adjusted gross income is less than $110,000 ($220,000 if you're filing a joint return) then you may be eligible to contribute to a Coverdell ESA. There are no limits on the number of separate Coverdell accounts that can be established for a beneficiary, but the total of all contributions to a beneficiary cannot exceed $2,000 in a single tax year.

Some of the other rules that apply to contributions include:

All contributions must be in cash.
All contributions must be made before the beneficiary reaches age 18, unless the beneficiary is a special needs student.
A Coverdell contribution cannot be invested in a life insurance contract.

In addition, the balance in the savings account must be distributed to the beneficiary within 30 days after reaching their 30th birthday or upon their death.

Coverdell ESA Tax Rules

While the contributions to a Coverdell ESA are not tax deductible, the beneficiary does not owe taxes on the distributions as long as they are less than their qualified education expenses. Qualified education expenses include:

A Coverdell ESA can be used to pay for eligible expenses at an elementary, secondary, and post-secondary school. These schools include public, private as well as religious schools providing education under state law from kindergarten through the college years.
In general, expenses include tuition, fees, books, supplies, equipment, tutoring, room, board, and transportation expenses.

If the distribution from a Coverdell education savings account is not used to pay for qualifying education expenses, then federal income taxes are owed on the portion of the distribution that has been allowed to grow tax-free in the account. In addition, taxable distributions from a Coverdell ESA may be subject to a 10% additional tax penalty on any amount included in income for that year.

Coverdell Rollovers

If there is a balance remaining in a Coverdell at the time a beneficiary reaches age 30, you can avoid the tax penalties mentioned above by rolling over, or transferring, the account balance to another Coverdell education savings account. Coverdell account rollovers can be established for another member of the beneficiary's family including:

A child or grandchild
A bother, sister, step brother or step sister
Father or mother
Son or daughter of a brother or sister
Aunts, uncles, first cousins, in-laws, and their spouses

Beneficiaries can be changed and the account can be transferred to another member of the beneficiary's family without incurring a tax penalty as long as the new beneficiary is under age 30.

Benefits of Coverdell ESA

Finally, in this world of 529 college savings plans, some of you might be wondering what the benefits of a Coverdell are relative to those college savings plans. The two most significant and unique benefits of Coverdell accounts include:

Eligible Educational Institutions - Coverdell ESA can be use to pay for expenses or educational institutions from kindergarten through college.
Flexibility of Investment - Coverdell accounts are much more flexible when it comes to investment options than 529 plans - which may be limited to certain types of investments.

Comparing Coverdell ESA to 529 Plans

Let's face it, to most of us saving for college we really only have a choice between the Coverdell Education Savings Account and 529 plans. So it's important to understand the exact differences and similarities between these two college savings plans.

Similarities Between Coverdell ESA and 529 Plans

Some of the more important similarities between Coverdell ESA and 529 plans include:

Switching Beneficiaries - Both savings plans allow the custodian or account holder to switch between beneficiaries without incurring a tax penalty provided the new beneficiary is an eligible family member.
Federal Financial Aid - Money in either a Coverdell ESA or 529 plan is considered the beneficiary's money when you're applying for federal financial aid. This can reduce the total amount of aid the student receives.

Differences Between Coverdell ESA and 529 Plans

Some of the more important differences between Coverdell ESA and 529 plans include:

Investment Options - Coverdell ESAs offer the investor a lot of flexibility when it comes to where the money can be invested - including stocks, bonds and mutual funds. With a 529 plan, your options may be very limited, especially with certain state run plans.
Plan Withdrawals - 529 plans have no age limit on account beneficiaries. With a Coverdell ESA, the money must be disbursed by the time the plan's beneficiary reaches age 30 or transferred / gifted to another family member that is age 29 or younger.
Contribution Limits - Coverdell Education Savings Accounts limit contributions to $2,000 per beneficiary per year. In contrast, 529 plans have virtually no limit on contributions.
Contribution Rules - with a 529 plan there are no restrictions with respect to income limits. Coverdell ESAs do have income limits for taxpayers that want to donate funds to an account.
Qualified Education Institutions - Coverdell ESAs have a much broader definition of qualified educational institutions including elementary schools. With a 529 plan, you're limited to institutions of higher education such as colleges and universities.