There are a few different ways you can save for your child’s college education, including 529 plans, a traditional savings account and Coverdell education savings accounts (Coverdell ESAs).
If you’re planning to save for college and want to use a Coverdell ESA, make sure you know all the rules before setting one up. Most importantly, you can only contribute until the beneficiary turns 18, and unused Coverdell ESA funds must be either withdrawn or rolled over into a new account before the beneficiary reaches the age of 30.
What is a Coverdell ESA?
A Coverdell education savings account, or Coverdell ESA, is a savings plan made for education-related expenses, whether that’s for college, elementary or secondary education.
When you create a Coverdell ESA, the beneficiary must be under the age of 18 (unless it’s for a beneficiary with special needs), and you can’t make contributions after the beneficiary has reached 18 years of age.
You can contribute up to $2,000 a year for each beneficiary depending on your modified adjusted gross income. The limit is phased out if your MAGI is between $95,000 and $110,000 (or between $190,000 and $220,000 for joint filers). If your MAGI is more than $110,000 (or $220,000 if you’re filing jointly), you can’t make any contributions.
Coverdell ESAs are a type of investment account where you can choose whichever specific investments you’d like the money to go toward. If you have a 529 plan, you don’t have the same freedom to choose any investment for your account.
Who should invest in an ESA?
A Coverdell ESA isn’t for everyone. The modified adjusted gross income limitations mean that not every household qualifies to contribute to one. If your MAGI is $95,000 or less (or less than $190,000 for joint filers), a Coverdell ESA makes sense. But if you earn too much, you won’t qualify to open a Coverdell account.
Anyone can contribute to a Coverdell account for a qualified beneficiary as long as their income allows it. But the contributions — from all sources — can’t be more than $2,000 a year.
A Coverdell ESA is best for parents who can contribute the maximum amount as early as possible. For instance, if you open an account in the first year of your child’s life and make the maximum contribution each year, they will have $36,000 by the time they graduate from high school. You can’t make contributions after the beneficiary turns 18.
What are some tax implications of a Coverdell ESA?
Contributions to Coverdell accounts are not tax deductible. However, the earnings in Coverdell accounts grow tax-free, and withdrawals are tax deductible as long as they go to qualified education expenses.
If withdrawals don’t go toward qualifying education expenses, you could face a 10 percent tax penalty.
The beneficiary only has until age 30 to use Coverdell funds. Once they reach 30 years of age, the remaining account funds must be withdrawn — regardless of how the funds are used (this doesn’t apply to beneficiaries with special needs).
What are the rules for contributing to and withdrawing from an ESA?
A Coverdell ESA has specific contribution and withdraw requirements, including:
The account limits contributions to $2,000 annually.
Your modified adjusted gross income could limit how much you contribute (or if you can contribute at all).
Funds must be used for education expenses, from elementary all the way up through college, or else you’ll face a 10 percent tax penalty.
Contributions can only be made until the beneficiary turns 18 years of age.
Any money left after the beneficiary turns 30 must be withdrawn within 30 days of their birthday.
Since not everyone qualifies for a Coverdell ESA, you might want to consider alternative college savings plans, like a 529 plan, Roth IRA or a traditional savings account.
What happens to unused ESA funds?
There’s a chance you may not use all the funds in your Coverdell ESA account. If you have money left over, there are a few things to do with it:
Roll it over: You can roll over unused Coverdell money to another account for an eligible family member, or you can change the beneficiary for the current account. You can also transfer it to a 529 plan, which is a qualified distribution, to avoid the tax penalty.
Withdraw it: The funds need to be withdrawn by the time the beneficiary hits 30 years of age. Whether you use the money for qualifying education expenses or not, you’ll need to take it out of the account or risk losing it.
The bottom line
While a Coverdell ESA is one college savings option, it’s not your only option. Before you choose a Coverdell account, make sure you qualify to open and contribute to one first. You can open up a Coverdell ESA wherever brokerages or investment firms offer them. Not every firm or company offers Coverdell, which means that you’ll need to check out your options before starting the application process.
If you don’t qualify for a Coverdell ESA, look at other college savings options, like a 529 plan, regular savings plan or another investment account. You may want to try a mix of a few different options to lower your risk.
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