Personal Finance: The Benefits of Coverdell ESAs

Setting aside money for future educational needs is a worthy personal finance goal, one that the U.S. government seeks to encourage through various tax-advantaged investment vehicles. Coverdell Education Savings Accounts–also known as Coverdell ESAs–have a number of benefits that can serve those seeking to set aside money for educational expenses down the road.

Learning about the benefits–and restrictions–of Coverdell ESAs can help you decide if it is the right investment vehicle for you to begin saving money for your children’s school.

What is a Coverdell ESA?

Named after U.S. Senator Paul Coverdell, who sponsored the legislation creating this investment vehicle, Coverdell ESAs are accounts that are designed to support savings for higher education.

Contributions are made with after-tax income, meaning that you cannot deduct these funds from your income tax obligations. However, the money placed in your Coverdell ESA is invested and will grow tax-free. Assuming the funds are put towards qualified educational expenses, they can also be withdrawn and used tax-free.

These qualified expenses can be traditional costs such as tuition, fees, books, and housing, but they can also extend to other educational needs such as student activity fees, supplies, and even transportation. Coverdell ESAs also afford you the freedom to use these funds for K-12 tuition and other expenses.

You can open a Coverdell ESA at brokerages that offer this service, at which time you will designate a beneficiary. These are self-directed vehicles, so you will direct these monies into various investment vehicles that your chosen brokerage offers.

What Are the Benefits of a Coverdell ESA?

The biggest advantage of utilizing a Coverdell ESA is the tax-advantaged savings you will accrue for your beneficiary. However, setting up this account can also help you get used to the practice of saving money for school.

Coverdell ESAs share similarities with Roth investment vehicles, as the tax benefits accrue on the distribution side of the equation. Because they are also geared towards a specific purpose, you can change your investment strategy to grow more conservative as you approach the timeframe when the beneficiaries will need to draw upon the funds.

The existence of a savings account can also help incentivize you to make regular contributions toward your child’s educational funds. This can happen either via regular monthly contributions or when there is leftover money at the end of the month.

What Are the Restrictions of a Coverdell ESA?

There are a number of both contribution and distribution-related restrictions for Coverdell ESAs.

(1) Maximum annual contributions: While there is no limit on the amount of accounts a single beneficiary can hold, they can only receive up to $2,000 a year in contributions.

(2) Income limitations: Only those making modified adjusted gross income (MAGI) under a certain amount can make full contributions to Coverdell ESAs. This is currently $190,000 for joint filers and $95,000 for single filers. Joint filers making up to $220,000 can make reduced contributions; those earning over $220,000 cannot make any contributions.

Note: Any individual can make contributions to your child’s Coverdell ESA as long as they fall under these income limits. There are no income restrictions for organizations, corporations, or trusts, which can all make contributions to Coverdell ESAs.

(3) Age limits: The beneficiary must use the funds by the time they are 30 years old, though there is an exception for those with special needs. In addition, no contributions can be made after the beneficiary turns 18 years old.

(4) Taxes and penalties: If the beneficiary does not use the money for educational purposes by the time they are 30 years old, the account will be closed, and the beneficiary will be on the hook for paying taxes on this income, as well as a 10% penalty. The beneficiary can be changed to a younger family member, however, which would allow the account to remain open.

Coverdell ESAs vs. 529 Plans

Because both Coverdell ESAs and 529 plans each offer tax-advantaged savings for education, the two are often compared and contrasted. There is significant overlap between both options, though there are also some key differences between the two.

(1) Income limits: Coverdell ESAs have limits on the amount of income of those making contributions. There are no income restrictions for 529 plans.

(2) Age limits: Coverdell ESAs must be either spent, transferred to another beneficiary, or closed once the beneficiary turns 30. There are no age restrictions for 529 plans.

(3) Annual contributions: Each beneficiary can only receive up to $2,000 per year in annual contributions for Coverdell ESAs. There are no annual contribution limits for 529 plans, though there are limits on the maximum amount that can be placed in the 529 plan, which vary by state.

(4) Qualified expenses: Coverdell ESAs tend to allow for more flexibility regarding what qualifies as an educational expense. For instance, only K-12 up to $10,000 in annual tuition costs can be paid for from 529 plans, not other expenses related to K-12 schooling. Coverdell ESAs allow for additional K-12 costs, including tutoring and special needs services.

(5) Tax deductions: Contributions to Coverdell ESAs are not tax deductible. Depending on the state and your residency status, you may be able to receive state income deductions on your 529 plan contributions.

Conclusion: Make Sure to Save

Coverdell ESAs will help you to save money for future educational expenses. They are one of many options that will help individuals put money aside for school. These range from other tax-advantaged vehicles to savings accounts at your local bank.

While the direction you choose will have implications for both contributions and distributions, at the end of the day, the most important step you can take is to simply begin saving. Doing so when your child is young will allow you to put more money aside, as well as benefit from the magic of compound interest. Coverdell ESAs can help you do just that.

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