Last week, we covered the basic facts behind the 529 plan. Today, we’ll look at the Coverdell Education Savings Account (ESA), formerly known as an Education IRA. You have more options for investing and spending a Coverdell ESA, but the contribution rules are much stricter. This makes it a good but limited college savings option.
An ESA is very similar to a 529 plan. Like a 529 plan, you make a contribution into the account for future qualified educational expenses for a designated beneficiary. Contributions are not tax deductible. The investments in the account grow tax free. When it is time to use the account, the beneficiary may withdraw the money tax-free for qualified educational expenses at an eligible school. Qualified expenses include tuition, fees, room and board, books, supplies and equipment. Despite the similarities, there are some important distinctions between the two plans.
Setting Up and Contributing to a Coverdell ESAs
The first distinction between a 529 plan and an ESA l is the beneficiary rules. While you can set up a 529 plan for any beneficiary, a Coverdell beneficiary must be under the age of 18 or have special needs. You can’t add contributions once he is over 18 unless he has special needs.
While anyone can set up and contribute to a 529 plan, there are income restrictions for contributing to a Coverdell ESA. In order to fully contribute to an ESA, you must have a modified adjusted gross income of $95,000 for single filers, or $190,000 for couples. These amounts fully phase out at $110,000 for singles and $225,000 for couples.
If you do exceed those amounts, you can transfer money to the child and have them contribute to the plan. Contributors to a Coverdell do not have to have earned income.
Like IRAs, contributions can be made up until April 15 of the following year.
Also, while 529 plan contributions are not limited, Coverdell contributions are limited to $2000 per year for a beneficiary. If parents and grandparents set up ESA plans for a child, the total contributed in the year for all plans cannot exceed $2000. Unfortunately, this makes the plans unlikely to be able to fully fund college costs.
If you do exceed the $2000 limit, you can avoid the 6% tax penalty by withdrawing the excess money before May 31 of the following year.
Coverdell ESAs can be established at many banks and mutual fund companies. However, some of the biggest online investment services (Vanguard, Fidelity and T Rowe Price) do not currently offer these plans. SavingforCollege.com has a list of low cost ESA providers.
Investing in a Coverdell ESA
Like a 529 plan, Coverdell ESAs are investment vehicles. They grow according to how well the investments in the account perform. If the investments don’t do well, it is possible to lose money.
The advantage of a Coverdell plan is that the investments work like an IRA, while a 529 plan works like a 401K. A 529 plan has a limited range of investment options. Each plan has its own investment options, and you must choose between them.
A Coverdell has a much wider range of possibilities, including individual stocks and bonds. While you can’t invest in collectibles or life insurance, you still have wide discretion in your investments. This means it’s possible to earn higher returns on your investment.
Using a Coverdell ESA
The most important distinction is that a 529 Plan is only used for college expenses. A Coverdell account may be used for elementary and secondary school expenses as well. Want to send your kid to a private high school? This may be where you want to start saving some money.
Like the 529, the plan must be used at an eligible school. FAFSA’s list of eligible colleges for 529 plans also applies to Coverdell accounts. Rules for K-12 schools are as defined by your state law. This means even home school expenses can be covered by the ESA! There are also some additional expenses that the account can cover for elementary and secondary school students, including uniforms, tutoring, extended day programs and special needs assistance.
Coverdell ESAs are treated the same as 529 plans in financial aid calculations. They are parental assets if the parent controls the account, and student assets if the student owns the account.
A Coverdell account can only be used for the designated beneficiary. Unlike a 529 plan, the responsible individual is not considered the owner of the account and cannot take the money except for the designated beneficiary’s use. The designated beneficiary can take money out without a qualified educational expense, but will pay a 10% tax penalty. She will also have to pay taxes on the account’s earnings.
If the designated beneficiary does not use all of the Coverdell account by their 30th birthday, they are required to cash out the account within 30 days. To avoid this, the beneficiary or responsible individual may want to roll the account into a 529 plan or name a new beneficiary. The new beneficiary will have to be under the age of 30 and a relative of the beneficiary.
529 Plan versus Coverdell does not have to be an either/or decision. It is entirely possible for a beneficiary to have both a 529 and an ESA.
That’s a good thing, because a Coverdell ESA is unlikely to cover the entire cost of college. However, the ESA’s greater flexibility make it useful for helping pay for pre-college educational expenses. It can be especially useful for saving for the education of a child with special needs. If you need to save for private K-12 education, it can be a very good savings vehicle.
This article is for informational purposes only. An investor interested in a college savings plan should proceed with caution and do lots of research before putting their money in any investment.