A Beginner's Guide to the Coverdell ESA

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It's no secret that American students are drowning in student debt. There was an estimated $1.7 trillion in student debt in 2020, and this number continues to grow. The cost for a full-time undergraduate in the U.S. in 2019 (including tuition, fees, and housing) averaged $20,598 for a public, in-state, four-year institution, and $26,382 for a public, out-of-state, four-year institution in 2019 and 2020.

Parents, grandparents, and other family members looking to get a head start on supporting their loved ones' college education might want to 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 whether 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 they'll grow through tax deferment. Non-qualified withdrawals might be taxed, while money withdrawn for qualified educational expenses won't be taxed.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:

  • The designated beneficiary must be under the age of 18 or a special-needs beneficiary, at the time the account is established.
  • 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 it must meet the IRS requirements for the year in which it's created.

If the money isn't 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
  • Income below the maximum limits for contributors ($110,000 for single filers, $220,000 for married couples in 2020)

Potential Advantages

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 529 plans, which limit how parents can invest the funds, Coverdell ESA investors can choose to invest in whatever stocks, bonds, CDs, and mutual funds they believe will have the most growth potential over the life of their investment.

Potential Disadvantages

The biggest disadvantage for parents and donors is the rule requiring that you either distribute the Coverdell ESA by the time the child turns 30 or roll it over to another child.

The funds will be forced out at a 10% penalty, and income tax will come due if the funds aren't removed from the account, (for example, if the beneficiary decides not to attend college or suffers an emergency that prevents them from doing so). Parents can simply change the beneficiary to someone under the age of 30 or transfer funds to a Section 529 plan to circumvent this result.

It will be considered a "qualified distribution" if you decide to transfer funds from a Coverdell to a Section 529, so no income tax or penalty tax will be due.

What Tax Benefits Can You Expect?

You won't receive a tax deduction for putting money into a Coverdell ESA. Contributions are made with after-tax dollars. They won't 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 don't 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, however.

What Are Eligible Expenses for a Coverdell ESA?

A Coverdell ESA owner can take a tax-free distribution on behalf of the beneficiary for qualified educational expenses. The IRS has gracious standards about what can be claimed as an educational expense, including:

  • Tuition, room, and board
  • Computers and laptops (even if not required by the school)
  • Books and supplies
  • Tutoring
  • Transportation

Coverdell ESA and Federal Financial Aid

Coverdell ESAs can affect financial aid significantly or not at all. It depends on who is designated as the “owner” of the account. The owner is the individual who sets up the account. It's not the person who is eventually going to college. They're the “designated beneficiary."

Here are some points to consider:

  • None of the assets is counted against financial aid if the child is both the owner and the designated beneficiary, and is still considered a dependent of the parents.
  • If the child is both the owner and the designated beneficiary and is considered independent of the parents, 20% of the assets are counted against financial aid. This dropped from 35% in 2007.
  • If the owner is a parent, 5.64% of the assets are counted against financial aid.
  • The assets don't count against financial aid at all if the owner is a grandparent, a member of the extended family, or an unrelated individual. This is because there's 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 at any time. This might include making the Coverdell ESA assets of the parents, or changing any of other terms. 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.

Contribution Rules

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.

The total contributions for a given year can't exceed $2,000 for all Coverdell accounts if a child has more than one. For example, one might have been established by their parents and another by a grandparent. There is no limit to how many accounts a beneficiary can have, as long as the total contributions for a year don't top $2,000.

The full $2,000 contribution can only be made by individuals whose “modified adjusted gross incomes” (MAGIs) are below a certain dollar amount in the year they contribute. They can make a partial contribution if their income is above this amount, but below the “ceiling."

The limits for taxpayers claiming single, head-of-household, or married-filing-separately status are:

  • 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 married-filing-jointly status, the limits are:

  • 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.

Contribution Deadline

Contributions to a Coverdell ESA for the previous year must be made by the contributor’s tax-filing deadline, excluding extensions. You would typically have until April 15 to make a contribution for the previous tax year, even if you file an extension with the IRS.

The IRS extended several tax deadlines for the 2020 tax year. The deadline for individual tax returns, tax payments, retirement account contributions, and Coverdell ESA contributions was extended to May 17, 2021. Residents of Oklahoma, Louisiana, and Texas have until June 15, 2021, to make contributions for the 2020 tax year. Their tax-filing deadline was extended in response to the 2021 severe winter storms.

Withdrawal Rules

There are no taxes or penalties on withdrawals made to fund educational expenses, provided that the withdrawal doesn’t exceed the actual amount of expenses. A portion will be subject to taxation and penalties if excess funds are withdrawn.

Assets remaining in the account must be distributed when the designated beneficiary reaches age 30, unless he or she is a special-needs beneficiary. The funds can be left in the account for a longer period of time in this case.

Treatment of Unused Funds

The IRS permits the funds to be transferred into another Coverdell ESA for someone who is related to the first beneficiary and under age 30. Related parties include immediate family members of the original beneficiary, parents, cousins, aunts, uncles, and even in-laws.