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. Some examples of qualified expenses include tuition and fees, books, supplies and equipment, and in many cases, room and board.
One feature that sets it apart from the 529 plan is the ability to use it for qualified expenses at any education level, including kindergarten to high school and post secondary (college level), provided the school is eligible to accept Coverdell funds.
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, however, the total annual contributions to the recipient cannot exceed $2,000 per year from all sources.
ESA Contribution and income limits
To be able to contribute the maximum amount, 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 own Coverdell ESA.
Where to open a Coverdell Educational Savings Account
You can open a Coverdell ESA at almost any traditional or online brokerage, along with many banks, mutual fund houses, and any financial institution which can serve as a custodian for a Traditional IRA. The contribution deadline is the same as the tax filing deadline, or April 15th in most years. The contributions can be invested in stocks, bonds, mutual funds, CDs, and similar investments.
Coverdell ESA withdrawals
Coverdell ESA withdrawals can be used for qualified expenses for students attending K-12 and/or higher education. Withdrawals are tax free if used for qualified expenses, otherwise the recipient may be required to pay early withdrawal penalties on the funds.
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 contribution and the requirement to use the assets by age 30.
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