Coverdell Education Savings Accounts (ESAs)


Coverdell Education Savings Plans

Families can save for college and K-12 expenses using a Coverdell Education Savings Accounts (ESA), previously known as Education IRAs.

Coverdell ESAs are less popular than 529 college savings plans, but have some advantages over them when saving for elementary and secondary school. 

But are these advantages significant enough to make it worth your while to open a Coverdell ESA? Continue reading to learn the pros and cons of Coverdell Education Savings Accounts to help you decide.

Advantages Of Coverdell Education Savings Accounts

Coverdell Education Savings Accounts have a few advantages that can make them worth considering. Here are a few of their most noteworthy benefits.

More Qualified Education Expenses

Like 529 plans, Coverdell ESAs provide for tax-free distributions to pay for qualified education expenses. However, Coverdell ESAs have a broader list of qualified expenses than 529 plans and fewer restrictions. 

While 529 plans can only be used to pay for up to $10,000 a year in K-12 tuition and fees, Coverdell ESAs don’t have a limit on K-12 education expenses. Coverdell Education Savings Accounts can also be used to pay for things like academic tutoring, special needs services, uniforms, and more.

Eligible Institutions

Eligible institutions are the same for both Coverdell ESAs and 529 plans. They include any college eligible for Title IV federal student aid and any elementary or secondary school under state law, including home schools.

Broader Choice Of Investments

Investors in a Coverdell ESA have more control over the investments than investors in 529 plans. 529 plans are typically limited to a few dozen mutual funds selected by the plan administrator. Coverdell Education Savings Accounts can be invested in individual stocks and bonds. They cannot, however, be invested in life insurance contracts.

Disadvantages Of Coverdell Education Savings Accounts

Coverdell Education Savings Accounts are more limiting than 529 plans in several important ways.

Annual Contribution Limit

There is a $2,000 annual contribution limit per beneficiary. This is a combined limit that applies to all contributions from all sources to all of the beneficiary’s Coverdell ESAs. 529 plans do not have an annual contribution limit, other than the annual gift tax exclusion. 

Excess contributions over $2,000 are subject to a 6% excise tax penalty unless they are withdrawn by May 31. Parents can learn about excess contributions made by relatives when they receive IRS Form 5498.

Taxpayers can choose to count contributions made by the due date on the federal income tax return, not including extensions, toward the previous year’s contribution limit. 

Related: 529 Plan Contribution Limits

Beneficiary Age Limit On Contributions

Contributions to a Coverdell Education Savings Account must stop when the beneficiary reaches age 18, except for special needs beneficiaries.

Contributor Income Limit On Contributions

There is an income limit on contributions. The contributor must have an adjusted gross income that is less than $110,000 (single) or $220,000 (married filing jointly). The annual contribution limit starts being phased out at $95,000 (single) and $190,000 (married filing joint). These income limits are not adjusted for inflation.

There are workarounds for the income limit on contributions. Parents can gift the money to the child and have the child make the contribution to the Coverdell ESA. There is no requirement for the child to have earned income, unlike an IRA. Contributions can also be made from corporations and trusts without an income limitation.

Beneficiary Age Limit On Distributions

The Coverdell Education Savings Account must be fully distributed by the time the beneficiary reaches age 30, except for special needs beneficiaries. An alternative is to change the beneficiary of the Coverdell ESA to a member of the family of the current beneficiary, if the new beneficiary is under age 30. 

Shared Provisions

Coverdell Education Savings Accounts share many of the same conditions as 529 plans. Here’s a quick list:

  • Contributions are made with after-tax dollars, must be made in cash and are not deductible.
  • Qualified expenses are reduced by tax-free scholarships, grants and fellowships, veterans’ educational assistance, employer tuition assistance, the American Opportunity Tax Credit (AOTC), the Lifetime Learning Tax Credit (LLTC) and tax-free distributions from 529 plans and prepaid tuition plans.
  • The earnings portion of a non-qualified distribution is subject to income tax at the beneficiary’s rate plus a 10% tax penalty. The tax penalty is waived if the beneficiary dies or becomes disabled. The tax penalty is also waived to the extent that the beneficiary’s qualified education expenses are reduced because of a tax-free scholarship or grant, the American Opportunity Tax Credit, Lifetime Learning Tax Credit, or other tax-free educational assistance.
  • Coverdell ESAs have the same favorable financial aid treatment as 529 plans. They are reported as a parent asset on the Free Application for Federal Student Aid (FAFSA) and distributions are ignored. 

Change In Beneficiary

The beneficiary of a Coverdell education savings account can be changed to a member of the beneficiary’s family, just as with 529 plans. But the new beneficiary must be under age 30.

Eligible members of the family include the beneficiary’s:

  • Spouse
  • Children (including stepchildren, foster children and adopted children) and their descendants
  • Siblings (including stepbrothers and stepsisters)
  • Parents (including stepparents) and their ancestors
  • Nephews and nieces
  • Aunts and uncles
  • In-laws (including son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, and sister-in-law)

Spouses of any of the above members are also eligible to become the new beneficiary of a Coverdell ESA. Members of the beneficiary’s family also include first cousins, but not their spouses.

Rollovers

Rollover contributions are not subject to the income limits or excise taxes. Rollovers are also not subject to contribution limits.

You can rollover from a Coverdell ESA to a 529 plan, but not vice versa. The 529 plan must have the same beneficiary as the Coverdell ESA. So, if the beneficiary is approaching the age 30 limit, one workaround is to rollover the money into a 529 plan

Only one rollover is allowed per 12-month period. But you can do an unlimited number of trustee-to-trustee transfers. Rollovers must occur within 60 days if they aren’t made through a trustee-to-trustee transfer. 

Coverdell ESAs can be transferred to the beneficiary’s former spouse as part of a divorce decree or separation agreement. Such a transfer is not taxable.

Final Thoughts

If you’re looking to save for elementary, middle school, or high school tuition costs, a Coverdell ESA can be a strong choice. Unlike 529 plans, Coverdell Education Savings Accounts don’t have annual limits on tax-free withdrawals for K-12 expenses.

However, 529 plans are likely to be more appealing to college savers since they have virtually no annual contribution limits. Coverdell ESA contributions, meanwhile, can’t exceed $2,000 per year per beneficiary. That’s pretty limiting when you’re trying to save for expensive college tuition costs.

Still not sure which account you should choose? Learn more about your various education savings account options here >>>



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