Like the 529 College Savings Plan, the Coverdell Educational Savings Account (ESA) is a tax advantaged college savings vehicle. However, there are some major differences between the two types college savings accounts. This article will cover the major features of Coverdell ESAs, and a later article will compare the two accounts.
How does a Coverdell Educational Savings Account work?
The Coverdell ESA works much like a Roth IRA, and at one point was called the Education IRA. Contributions are non-deductible and grow tax free. Withdrawals are also tax free for qualified higher education expenses.
ESA Contribution and income limits. Contributions to Coverdell ESAs are limited at $2,000 per year from all sources (limit drops to $500 in 2010 if Congress does not extend the current contribution limits). To make the maximum contribution, contributors must have an AGI lower than $95,000 for single filers and $190,000 for joint filers. Contribution limits are phased out for AGI levels between $95,000 – $110,000 for single filers and $190,000 – $220,000 for joint filers. To avoid the income limits and make the full contributions, you can gift the money to the minor and they can contribute it to their Coverdell ESA.
Coverdell ESA eligibility. The beneficiary of the Coverdell ESA must be younger than 18 at the time the contribution is made and the assets must be used or transferred to another beneficiary by the time he or she turns 30. There is no limit to how many accounts can be opened per person, but there may be penalties if the total contributions exceed the $2,000 per year contribution limit.
Coverdell ESA investments. The contributions can be invested in stocks, bonds, mutual funds, and CDs, and you can open a Coverdell ESA at any place that can serve as a custodian for a Traditional IRA, such as a bank, mutual fund company, some discount brokerages, or other financial institutions.
Use it, transfer it, or pay taxes
The money contributed to a Coverdell ESA is for educational use only, and you cannot withdraw your contributions for personal use (which differs from the 529 College Savings Plan). If the beneficiary does not use the assets in the Coverdell ESA by the time they turn 30, then there are two options for the money:
- Assets are automatically distributed and will be subject to taxes and penalties.
- Assets can be transferred to another relative.
Coverdell ESA accounts offer tax benefits but have some limitations
ESAs offer great tax benefits for college savings but they are somewhat more restrictive than the 529 College Savings Plan. The biggest downsides are the $2,000 per year maximum contirubtion and the requirement to use the assets by age 30.
More college savings articles:
{ 9 comments… read them below or add one }
Thanks for this information on the Coverdell. We’re trying to decide whether to go with a Coverdell, 529 or both. We want our son to help by contributing his own money as well.
CashMoney,
A planner came into my office today, and asked me why would anyone choose the Coverdell? I can’t think of one reason – can you?
My Journey: The biggest reason someone would open a Coverdell is that you can change the asset allocation and investments at will, where you can only do it twice per year with a 429 plan. There are a couple other small reasons, but overall, I think the 529 is a more flexible plan.
Patrick:
Does the contribution limit of $2,000 apply if a Coverdell account is transferred to another relative? What if the amount to be transferred is more than $2,000?
Thanks.
Michelle, The $2,000 is the max any one person can have contributed to his or her account in any given year, regardless of how many people contribute to it. For example, you could contribute $1,000 to your child’s fund and your parents could also contribute another $1,000 to the fund and it would be maxed out. You couldn’t both contribute $2,000. I believe the limit only applies to contributions; I’m not sure about transfers.
Can a Coverdell ESA be used for expenses related to homeschooling, for example textbooks, resources materials, educational videos?
Paul, I believe so, I would just recommend keeping receipts of everything so you can prove the costs were school related, should there ever be any questions about it. If you are unsure, then I recommend contacting your plan administrator or a tax professional for more information.
Did Congress act to keep the limit at $2,000 or has it reverted to $500?
Ben, From what I have seen, the limits are $2,000 for 2010.