Formerly known as Education IRAs, the Coverdell Education Savings Account can be an excellent way to save for college. While they cannot rival 529 plans in terms of contributions, under certain conditions they can offer more flexibility.
In this article, we'll run through the similarities and differences between Coverdell ESAs and 529 plans. That discussion will include tax benefits as well as contribution limits. We'll also talk about beneficiary and rollover rules as well as the long term effectiveness of these accounts.
Coverdell ESA and 529 Plans
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The 529 Plan is frequently touted as the best investment option available to pay for school. That may be true for individuals trying to play catch-up, or those enjoying a monetary windfall that can be put into a college savings account. But the Coverdell Education Savings Account, or Coverdell ESA, offers parents that are saving for college another great option too.
Similarities
The following list summarizes some of the similarities between Coverdell ESAs and 529 plans.
Tax-advantaged, if the money is used to pay for higher education expenses.
Custodians of the account have flexibility in choosing the beneficiary.
Money in both plans is considered the beneficiary's money when applying for federal financial aid. This could lower the amount of student aid received.
Differences
There are some important differences parents should be aware of before choosing between a Coverdell ESA and a 529 plan:
Contribution limits for Coverdell ESAs are much lower than 529 plans. While the annual contributions are almost limitless for 529 plans, Coverdell's contributions are limited to $2,000.
Coverdell ESAs can offer investors a much broader range of investment options when compared to state run 529 plans.
Coverdell ESAs offer greater flexibility in terms of how the money is used. For example, the account can be used to pay for expenses of qualified elementary and secondary schools.
529 plans do not have age limits on beneficiaries, while Coverdell ESAs must be used, or rolled-over to another beneficiary, by age 30.
Contribution Limits
The Coverdell ESA's annual contribution limit for each child increased to $2,000 per beneficiary several years ago. This was a substantial increase from the Education IRA's $500 limit. In addition, the income limit for making a maximum contribution now stands at $190,000 for married couples filing joint tax returns, and contributions phase out at $220,000 in 2020 and 2021. For those not filing a joint return, the contribution limit is $110,000.
Anyone can establish a Coverdell for a child or beneficiary, and there can be multiple savings accounts established for the same child as long as the $2,000 annual limit is maintained. This is the total of all accounts directed to one child in a calendar year.
Tax Implications
The contributions to a Coverdell ESA are not tax deductible, but money deposited in the account will grow tax-free until distributions are taken. If the distribution from an account is not more than the beneficiary's qualified education expenses, the beneficiary will not owe federal income taxes.
Eligible educational institutions can be either postsecondary schools or an eligible elementary or secondary school. This would apply to a college, university, vocational school, or other postsecondary educational institution that is eligible to participate in a student aid program administered by the Department of Education. This would also include virtually all accredited, public and nonprofit postsecondary institutions. Anyone unsure if an educational institution is qualified should speak to someone in the financial aid office.
Beneficiary Rules
Unless the beneficiary is a special needs student, then contributions cannot be made into the account after the beneficiary reaches age 18. The balance of the account must be distributed within 30 days after the beneficiary reaches the age of 30, once again, unless the beneficiary is a special needs student.
Rollovers
One way of avoiding an unwanted distribution is to take advantage of the rollover provision for Coverdell ESAs. Distributed amounts are not subject to federal income taxes if they are rolled-over to another ESA for the benefit of the same beneficiary or a member of the beneficiary's family that is under the age of 30 including:
A son or daughter or descendant of a son or daughter.
Stepsons, stepdaughters, brothers, sisters, stepbrothers, or stepsisters.
Father or mother or an ancestor of the father or mother.
Stepfather or stepmother.
Son or daughter of a brother or sister: nieces and nephews.
Brother or sister of father or mother: aunts and uncles.
Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
The spouse of any the individuals listed above.
First cousins
Value of the Coverdell ESA
To summarize, Coverdell accounts offer individuals a simple savings mechanism for future education expenses. While $2,000 a year might not sound like a lot of money, it does add up. For example, let's assume this limit is never increased, which is unlikely. A parent or guardian putting away the maximum each year for a child starting at birth and earning 6% on the account, would have over $60,000 when that child reaches age 18.
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