While some service members may pass GI Bill education benefits to their children, not everyone qualifies for this option. This begs the question: what are the best ways to save for my child’s education? In this article, we’ll outline one available option, the Coverdell Education Savings Account (ESA).
Specifically, we’ll discuss the following:
- What is the Coverdell Education Savings Account?
- Contributing to a Coverdell ESA
- Qualified Education Expenses and ESA Distributions
- Coverdell ESA Alternative
- Final Thoughts
What is the Coverdell Education Savings Account?
A Coverdell education savings account, or ESA, provides US taxpayers a tax-advantaged way to save for a beneficiary’s education. More precisely, Coverdell ESAs are trusts or custodial accounts established in the United States and used for paying qualified education expenses for a designated beneficiary.
While contributions to a Coverdell aren’t tax deductible, the earnings are tax-exempt, so long as they’re used for qualified education expenses. In other words, beneficiaries do not need to pay taxes on Coverdell distributions, so long as they use these funds for approved expenses. Formerly, these funds could only be used for higher education expenses. Now, beneficiaries can also apply Coverdell funds to qualified elementary and secondary education expenses.
Typically, a parent creates a Coverdell account to fund a child’s future education expenses, but you don’t need to be a beneficiary’s parent – or even family member – to open an account. Instead, to open a Coverdell ESA, the following requirements must be met:
- When the account is established, the designated beneficiary must be under the age of 18 or be a special needs beneficiary.
- The account must be designated as a Coverdell ESA when it is created.
- The document creating and governing the account must be in writing, and it must meet certain requirements.
Most banks and financial institutions offer Coverdell accounts. To open one, you’ll first need to confirm that your particular institution does, in fact, offer the accounts. Next, you’ll need proof of the beneficiary’s date of birth, name, and social security number.
Contributing to a Coverdell ESA
Who Can Contribute?
To contribute to a Coverdell ESA, you must have a modified adjusted gross income (AGI) beneath a certain ceiling (this ceiling is regularly adjusted for inflation). If you exceed this ceiling and still contribute to a Coverdell, the IRS will impose a 6% excise tax on the contributions. However, despite the income ceiling on individual contributions, any organization (e.g. corporations or trusts) can contribute to an account, regardless of their AGI.
Coverdell contributions must be made in cash (i.e. you cannot contribute stocks, funds, or other assets to an account). All contributions – from individuals or organizations – must be made by the due date of their tax return.
Annual Contribution Limits
No limit exists to the number of Coverdell accounts that can be established for a given beneficiary. But, there is a maximum total annual contribution for a single beneficiary – $2,000 per year. That is, regardless of the number of accounts and contributors, no Coverdell beneficiary can receive more than $2,000 into his or her account(s) in a given tax year.
As stated, you don’t receive a tax deduction for contributions to a Coverdell. But, because the earnings on those contributions aren’t taxed, these accounts can be great options for saving for someone’s education. For example, say you contribute to $2,000 – the annual limit – to your child’s account shortly after birth. Assuming 7% growth, that $2,000 will have grown to nearly $6,800 18 years later. If used for qualified education expenses, your child can withdraw that $6,800 – entirely tax-free! In other words, you save the taxes you would normally need to pay on the $4,800 in investment earnings from that initial contribution.
Qualified Education Expenses and ESA Distributions
According to the IRS, Coverdell distributions are tax-free to the extent the amount of the distributions doesn’t exceed the beneficiary’s qualified education expenses. If a distribution exceeds the beneficiary’s qualified education expenses, a portion of the earnings is taxable to the beneficiary.
But, this begs the question: what, exactly, are qualified education expenses? Generally speaking, the costs of attending a school (or providing for a special needs beneficiary) qualify, and these costs include:
- Tuition and fees
- Other required materials for a particular course of study
- Room and board (in certain situations)
However, to avoid unintended tax consequences, beneficiaries also need to understand what isn’t a qualified education expense. The following items do not qualify:
- Student health and medical expenses
- Transportation to/from and around school
- Expenses for extracurricular activities (e.g. athletics or clubs)
Coverdell Compliance and IRS Form 1099-Q
Unless a beneficiary qualifies as a special needs beneficiary, all amounts remaining in a Coverdell account must be distributed at age 30. Technically, these funds need to be withdrawn within 30 days of a beneficiary’s 30th birthday. And, in addition to qualifying as taxable income to the beneficiary, this distribution triggers a 10% penalty. Alternatively, a Coverdell account can be transferred to another eligible beneficiary within the family to avoid this mandatory distribution.
To report Coverdell distributions on their tax returns, beneficiaries will receive an IRS Form 1099-Q, Payments from Qualified Education Programs.
Coverdell ESA Alternative
College can be expensive. While Coverdell ESAs provide a tax-advantaged way to save for education, the $2,000 annual contribution ceiling limits savings potential. For example, say you fund your child’s Coverdell account at birth and then contribute $2,000/year for the next 17 years. At 7% growth, that will leave you with nearly $68,000. This certainly isn’t pocket change, but it also likely won’t cover four years of tuition at many universities.
Here’s an alternative, tax-advantaged option for college savings:
A 529 Plan lets you save for a beneficiary’s college expenses – like the Coverdell – but these accounts are not restricted by a $2,000 annual contribution. Rather, 529 contributions are treated as gifts by the IRS. And, individuals can currently give up to $15,000 per year to a beneficiary without paying any taxes.
With a 529 Plan, this annual gift can be amplified, as well. Through a process known as superfunding, the IRS allows you to contribute up to five years of tax-free contributions – $75,000 in total – at the beginning of every five-year period. If in a financial position to make such a contribution at birth, that $75,000 would grow to nearly $237,000 17 years later!
The Coverdell ESA provides individuals a tax-advantaged way to save for a beneficiary’s education. But, its annual contribution limit of $2,000 also significantly limits an account’s growth potential. As an alternative, parents, guardians, or other individuals saving for a child’s education may want to consider 529 Plans.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.