A Beginner's Guide to the Coverdell ESA
It's no secret that American students are drowning in student debt, there was an estimated $1.5 trillion in student debt in 2019, and this number continues to grow. In 2019-2020, the cost for a full-time undergraduate in the U.S. (including tuition, fees, and housing) averaged $21,950 for a public, in-state, 4-year institution, and $38,330 for a public, out-of-state, 4-year institution.
Parents, grandparents, and other family members looking to get a head start on supporting their loved one's college education should consider a Coverdell Education Savings Account (ESA).
Just like any investment, it's important to understand the finer details of this long-term savings tool, and this beginner's guide is a perfect place to start.
Speak with a financial advisor to get the latest details and receive personalized help to determine if the Coverdell ESA is right for you.
What Is a Coverdell ESA?
A Coverdell ESA allows up to $2,000 per child, per year in after-tax contributions to be made in a child’s name. These non-deductible contributions must be made in cash, but will grow through tax-deferment. Non-qualified withdrawals may be taxed, while money withdrawn for qualified educational expenses will not be taxed. The beneficiary pays the tax. This benefit applies not only to qualified higher education expenses, but also to qualified elementary and secondary education expenses.
According to the IRS, there are certain requirements to set up a Coverdell ESA:
- 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's created.
- The document creating and governing the account must be in writing, and must meet the shifting IRS requirements of the year in which it's created.
If the money is not used by the time the child turns 30, it must be given to them or rolled over to a Coverdell ESA for another family member.
Ideal Investors for a Coverdell ESA
A Coverdell ESA is ideal for parents or grandparents who have some combination of the following factors:
- Desire to help multiple children attend college
- Foresight in planning for college early in their beneficiary's life
- Aspiration to save a large, lump sum
- Beneficiary(s) attend private elementary or secondary schools
- Demand a high level of flexibility with investment choices
- Donor falls below the maximum income limits for contributors ($95,000 for single filers, $190,000 for married couples)
The primary advantage of a Coverdell ESA is that it allows for the tax-deferred growth of its assets, as well as tax-free distributions for qualified educational expenses. Unlike, Section 592 plans, which limit how parents can invest the funds, Coverdell ESA investors can choose to invest their funds in whatever stocks, bonds, CDs, and mutual funds they believe will have the most growth over the life of their investment.
Coverdell ESAs also allow for tax-free distributions to help pay for elementary, middle, and high school educational costs. This is not allowed in Section 529 plans.
The biggest disadvantage for parents and donors is the rule requiring you to either distribute the Coverdell ESA by the time the child turns 30 or roll it over to another child.
This means that if the funds are not removed from the account (because the beneficiary decides not to attend college, or suffers an emergency that prevents them from doing so), the funds will be forced out at a 10% penalty, as well as with income tax due. To circumvent this, parents can simply change the beneficiary to someone under the age of 30 or transfer funds to a Section 529 plan.
If you decide to transfer funds from a Coverdell to a Section 529, it will be considered a "qualified distribution" and thus no income tax or penalty tax will be due.
What Tax Benefits Can You Expect?
You won't receive any tax deduction for putting money into a Coverdell ESA. Contributions are made with after-tax dollars and will not lower your tax bill in the year you contribute.
The big tax benefit of the Coverdell ESA is that it allows for tax-deferred accumulation and tax-free withdrawals for qualified expenses. In other words, you do not have to pay tax on any of the annual growth of your original investment if the money is used for education. Non-qualified withdrawals will be taxed though.
What Are Eligible Expenses for a Coverdell ESA?
A Coverdell ESA owner may take a tax-free distribution on behalf of the beneficiary for qualified educational expenses.
The IRS has gracious standards about what may be claimed as an educational expense, including:
- Tuition, Room, and Board
- Computers and Laptops (even if not required by the school)
- Books and Supplies
Coverdell ESA and Federal Financial Aid
Coverdell ESAs may affect financial aid significantly, or not at all; it all depends on who is defined as the “owner” of the account. The owner is the person who sets up the account and not the person who is eventually going to college (they are the “designated beneficiary”). Here are some points to consider:
- If the child is both the owner and the designated beneficiary and is still considered a dependent of the parents, none of the assets are counted against financial aid.
- If the child is both the owner and the designated beneficiary and is considered independent of the parents, 20% (this dropped from 35% in 2007) of the assets are counted against financial aid.
- If the owner is a parent, then 5.64% of the assets are counted against financial aid.
- If the owner is a grandparent, a member of the extended family, or an unrelated individual, the assets do not count against financial aid at all. This is due to the fact that there is no place to report assets owned by people other than a parent or student on the FAFSA form.
Legislation in Congress can affect and change any of these general outlines in the future. That may include making the Coverdell ESA assets of the parents or changing any of the terms. Be sure to check with your financial advisor for the latest details and stay up to date on the developments if you decide to invest in a Coverdell ESA.
A child’s Coverdell ESA can accept contributions up until their 18th birthday. The maximum annual contribution allowed is $2,000 per designated beneficiary (not per adult contributor), per year.
If a child has more than one Coverdell account (for example, one established by their parents and another by a grandparent), the total contributions for a given year may not exceed $2,000 between all accounts.
The full $2,000 contribution may only be made by individuals whose “modified adjusted gross income” (or MAGI) is below a certain dollar amount in the year they contribute. If their income is above this amount, but below the “ceiling", they may make a partial contribution.
For taxpayers claiming a single, head-of-household, or married-filing-separately status:
- Less than $95,000 MAGI; the full $2,000 contribution is permitted.
- $95,000 to $110,000 MAGI; a partial contribution is permitted.
- More than $110,000 MAGI: no contribution is permitted.
For taxpayers claiming a married-filing-jointly status:
- Less than $190,000 MAGI; the full $2,000 contribution is permitted.
- $190,000 to $220,000 MAGI; a partial contribution is permitted.
- More than $220,000 MAGI; no contribution is permitted.
Contributions to a Coverdell ESA for the previous year must be made by the contributor’s tax-filing deadline, excluding extensions (you have until April 15, 2020, to make a contribution for your 2019 tax year, even if you file an extension with the IRS).
There are no taxes or penalties on withdrawals made to fund educational expenses, as long as the withdrawal doesn’t exceed the actual amount of expenses. If excess funds are withdrawn, a portion will be subject to taxation and penalties.
Amounts remaining in the account must be distributed when the designated beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary. In this case, the funds can be left in the account for a longer period of time.
Treatment of Unused Funds
The IRS permits the funds to be transferred into another Coverdell ESA for someone related to the first beneficiary, who is under 30-years old. Related parties include immediate family members of the original beneficiary, parents, cousins, aunts, uncles, and even in-laws.
Education Data. "Average Cost of College & Tuition." Accessed March 27, 2020.
IRS. "Topic No. 310 Coverdell Education Savings Accounts." Accessed March 27, 2020.