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What is the Coverdell ESA?

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Introducing the last account type on our quest to find the best way to save for college, the Coverdell ESA.

Without further delay, here’s what you need to know about the Coverdell ESA.

What is it?

Like the 529, the Coverdell ESA is an education savings vehicle for K-12 and secondary education. Coverdell ESA stands for Coverdell Education Savings Account.

It got its name from Senator Paul Coverdell, who introduced the legislation for a similar account, the Education IRA. In 2002, a new piece of legislation was introduced to make the account what it is today.

The 529 and the Coverdell ESA share many of the same characteristics, but there are some things that set it apart. All of these will be listed below.

Advantages

  • Savings and investments in the account grow tax-deferred and are withdrawn tax-free when used for qualified education expenses.
  • When it comes time to withdraw, those funds are not considered income, as long as you are using them for qualified education expenses.
  • Can use in conjunction with other education tax credits, like the Lifetime Learning Credit, as long as there’s no double-dipping.
  • These accounts are self-directed, so your investment options are plentiful. They include…
    • Age-based funds
    • Static mutual funds
    • ETFs
    • Stocks
    • Bonds
    • Real estate

Disadvantages

  • Contribution limit of $2,000 per child per year.
  • The funds inside the account are taken into consideration when you file for financial aid. The assets are considered their parents assets.
  • If the money is not withdrawn from the account by the time the beneficiary is 30, they could be subject to taxes and penalties.
    • After 30, the funds inside the account become fully taxable and you’re penalized 10%.
  • Like the 529, contributions to this account are not tax-deductible.

Unique Characteristics

  • Only eligible to families/individuals that fall below an income threshold ($110,000 for single taxpayers and $220,000 for couples who file jointly).
  • The contribution limit is $2,000 per child per year, so even if a family member opens an account for your child, you still can’t go over that number, or there will be a penalty.
  • Qualified expenses include…
    • Tuition
    • Books
    • Supplies
    • Equipment
    • Tutoring
    • Special needs services
  • And can also include…
    • Room and board
    • Uniforms
    • Supplementary and transportation services
  • With a 529, the account owner has control over the assets. Conversely, with a Coverdell ESA, the beneficiary has control.

Conclusion

Effectively, there are three education savings vehicles used today. The UTMA/UGMA, Coverdell ESA, and the 529 plan. I’ve written about the other two in the past so go check those out.

On paper, the 529 looks like the best option, with a high contribution limit, a large number of qualified expenses, and there’s no penalty for letting funds sit for decades.

That is all true, and honestly, I prefer the 529, but the vast, vast majority of people that are helping their children save for college will not come close to the high contribution limit.

The only drawback to the Coverdell ESA is the penalty if the funds aren’t used before 30. Other than that, I don’t think the $2,000 contribution limit is a factor because most people can’t put that much away, anyway. Not without sacrificing their ability to save for retirement, as well.

That said, they’re both great options and you can’t go wrong with either one.

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