The federal government provides a number of tax breaks that can help ease the financial burden of families saving for college. One of the ways to take advantage of these breaks is by opening a Coverdell Education Savings Account, or Coverdell ESA. At one time these were referred to as Education IRAs, but the Coverdell has a new name and some new rules too.
The "old" Education IRA was woefully behind the times when it came to saving for college. Those IRAs offered the accountholder the opportunity to set aside $500 each year; hardly enough money to make a dent in today's college tuition expenses.
Coverdell Education Savings Accounts not only carry a different name, but the rules have been updated too. A Coverdell ESA is a custodial account that can be used to pay for qualified education expenses of the beneficiary. The benefits of a Coverdell go beyond helping to pay for college expenses. If the taxpayer qualifies, they offer the possibility of tax breaks too.
Taxpayers with adjusted gross income less than $110,000 ($220,000 if filing a joint return) 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 single beneficiary cannot exceed $2,000 each tax year.
Some of the other rules that apply to these accounts include:
In addition, the balance in the savings account must be distributed no later than 30 days after the beneficiary reaches their 30th birthday, or upon their death.
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, which include:
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.
If there is a balance remaining in a Coverdell when the beneficiary reaches age 30, it's possible to avoid the tax penalties mentioned above by rolling over, or transferring, the account balance to another Coverdell ESA. Account rollovers can be established for another member of the beneficiary's family including:
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.
Finally, when evaluating college savings plans, it's a good idea to compare the benefits of a Coverdell to those of 529 plans. The two most significant, and unique, benefits of Coverdell accounts include:
For many, saving for college means choosing between the Coverdell ESA and a 529 plan. It's important to understand the exact differences, and similarities, between these two college savings mechanisms too.
Some of the important similarities between Coverdell ESAs and 529 plans include:
Some of the important differences between Coverdell ESAs and 529 plans include:
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