What Is a Coverdell ESA?
Originally called an education IRA (or individual retirement account), the Coverdell education savings account (ESA) takes its name from its original champion, Sen. Paul Coverdell. These custodial accounts allow parents, grandparents, and other family members to contribute money to an investment account for a child’s higher education expenses, with tax-free withdrawals once they reach college age.
It comes with a handful of rules like all tax-sheltered accounts. But when used correctly, it can save you significant money on taxes as you invest money for a younger family member’s education.
Coverdell ESAs work similarly to Roth IRAs. You don’t get an immediate tax deduction on contributions, but the money compounds and grows tax-free. Neither you nor your designated beneficiary pays income taxes on withdrawals.
Contributions count toward your annual gift tax exclusion. As long as you keep your total annual gifts under the excluded amount, you avoid any gift tax.
But you must use the money for qualified education expenses.
Allowed Education Expenses
Your beneficiary can tap their ESA for tuition, of course. But they can also use ESA funds to pay for books, supplies, and even a computer.
To qualify to use ESA funds, college and trade school beneficiaries must be enrolled in school at least half time. But parents can also use ESA funds to cover K-12 education expenses. That differentiates it from 529 college savings plans, which come with more restrictions.
Allowable ESA expenses include:
- Expenses of attending school, such as tuition, fees, books, supplies, required uniforms, room and board, and transportation
- Purchasing a computer or Internet access for the use of a student (as well as the student’s family) during the years the student is in school
- Special needs services
- Academic tutoring
If you take a distribution from an ESA for a nonqualifying expense, expect to pay the IRS a 10% penalty plus federal taxes on the gains (and state taxes if your state charges them).
Beneficiary Rules and Transfers
You must spend money in an ESA on qualified education expenses by the time the beneficiary turns 30. Otherwise, cue the taxes and penalties.
But you can transfer the funds to another beneficiary penalty- and tax-free. That way, if your child decides not to go to college, you can roll the funds over to another child, even one who’s not your own.
Or you can pull all the money out and eat the 10% penalty and taxes on the gains. But beware, once the beneficiary turns 30, they take control of the account and all the remaining funds. At that time, they receive any remaining balance in cash and pay the 10% penalty and gains taxes.
As a final beneficiary rule, you can only contribute to an ESA for a minor beneficiary. Once they turn 18, the door locks and funds can only flow outward unless the beneficiary has special needs.
Like Roth IRAs, you open and manage Coverdell ESAs through your investment brokerage.
That means you get to invest in whatever you want and manage your own investments. It also means you can automate the investments with a robo-advisor to minimize fees and fund-expense ratios.
That contrasts sharply with 529 plans, which operate at the state level and often come with few investment options.
While you can invest in any publicly traded paper assets like stocks, bonds, exchange-traded funds, and mutual funds, you can’t invest in “alternative” investments, like directly owned real estate, precious metals, collectibles, or individual businesses.
Unfortunately, Coverdell ESAs come with low contribution limits.
The total allowed contributions per child per year max out at just $2,000, a limit that hasn’t changed since 2002.
Notice that $2,000 is a combined limit for each beneficiary. If your child’s grandparents contribute $1,500 to their ESA, you can only contribute $500 that year. That means you have to coordinate carefully with other family members. If you accidentally contribute a combined total higher than $2,000, the IRS charges penalties and taxes.
In addition to low annual contribution limits, ESAs also come with income limits. The ability to contribute starts phasing out at a modified adjusted gross income, or MAGI, of $95,000 for single filers and disappears entirely at $110,000 ($190,000 to $220,000 for married couples).
Implications for Financial Aid
An ESA affects financial aid in the same way as most other assets. To optimize your child’s chances of getting aid, your child should not own the ESA, as students are expected to contribute 20% of their assets to education expenses. Parents are only expected to contribute 5.64% of theirs.
The financial aid office will determine that a larger pool of money is available for college if the child owns the ESA, making the child less likely to receive aid. Keeping the account in a parent’s or grandparent’s name takes care of that problem.
For further reading, learn about how both ESAs and 529 plans impact financial aid.
Key Differences Between ESAs & 529 Plans
The most significant difference between ESAs and 529 plans is that the federal government sets the rules for ESAs, while states operate the 529 plans. That means each state’s 529 plan is different.
You can use both the ESA and 529 plans to save for college. The primary advantage of the ESA is its flexibility. While you can only use a 529 plan to fund a qualified undergraduate or graduate-level education, an ESA can fund either one plus your child’s elementary or high school education.
Moreover, the ESA is more lenient about paying non-tuition educational expenses, whereas 529 plans typically allow only direct college expenses, such as tuition and books.
While ESA contributions remain low at $2,000 per child per year, 529 plans usually allow higher annual contributions. Many states allow you to deduct contributions from their state income tax return as well.
Notably, some states offer a completely different option for 529 plans: prepaid tuition. You pay a fixed amount today for your child’s future tuition, locking in that price — if your child attends college in that state. In contrast, ESAs operate as brokerage investment accounts.
As a final difference, 529 plans don’t come with the same age restrictions as ESAs.
Not sure whether to invest in a Coverdell ESA or a 529 plan?
Don’t lie awake at night wringing your hands because you can invest in both.
Saving for college doesn’t need to be difficult or complicated. That said, don’t fixate on saving money for your child’s education and ignore more creative ways to cover your child’s education costs. Your own savings should only make one piece of the puzzle.
Lastly, ensure you have your financial priorities in order. Your own retirement savings must come before your child’s education expenses. Your child has many ways to reduce or avoid college education debt, but your nest egg is your only protection against going broke in retirement.