Coverdell Education Savings Account

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.

Coverdell ESA Program

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.

Contribution Rules

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:

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

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.

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, which include:

  • Paying for eligible expenses at an elementary, secondary, and post-secondary school.  These schools include public, private, as well as religious institutions providing education under state law from kindergarten through the college years.
  • Generally, expenses include tuition, fees, books, supplies, equipment, tutoring, room, board, and transportation costs.

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.

Rollover Rules

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:

  • A child or grandchild
  • A brother, 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, 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:

  • Eligible Educational Institutions:  Coverdell ESAs can be used to pay for educational institution expenses 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 assets.

Comparing Coverdell ESA to 529 Plans

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.

Similarities between Coverdell ESAs and 529 Plans

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

  • Switching Beneficiaries:  Both savings plans allow the custodian, or accountholder, 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 a 529 plan is considered the beneficiary's money when applying for federal financial aid.  This can reduce the total amount of aid the student receives to help pay for college.

Differences between Coverdell ESAs and 529 Plans

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

  • Investment Options:  Coverdell ESAs offer the custodian of the account a lot of flexibility when it comes to where the money can be invested.  This includes stocks, bonds, and mutual funds.  With a 529 plan, the 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 ESAs limit contributions to $2,000 per beneficiary per tax year.  In contrast, 529 plans have virtually no limit on contributions with some plans allowing up to $300,000 per year.
  • 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.  Funds in a 529 plan are limited to costs associated with institutions of higher education such as colleges and universities.

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