A Coverdell ESA, formerly known as an Education IRA, is a tax-advantaged savings vehicle designed to help parents pay for the educational expenses of a child under the age of 18. It offers several benefits, but it’s not the only option out there. We’ll discuss the pros and cons of a Coverdell ESA to help you decide if it’s the right move for you and your family. If you need some hands-on help in planning to save for your child’s education, check out SmartAsset’s financial advisor matching tool to get paired up with an expert who suits your particular needs.
Benefits of a Coverdell ESA
Like the 529 plan, a Coverdell ESA is a common college savings account. But unlike 529s, Coverdell ESAs allow you to invest in virtually the entire securities world. You can build a portfolio with stocks, bonds, mutual funds and more. With a 529 plan, you’re limited to the investment options in the plan sponsored by the state you choose.
Your investments in a Coverdell ESA grow tax-free. Your withdrawals will also be protected from taxation as long as you use them on qualified educational expenses such as tuition, mandatory fees and course-required textbooks.Coverdell ESA Contribution Limits and Rules
The annual contribution limit for a Coverdell ESA is $2,000. However, contribution rules work similarly to those of a 401(k) plan. So you can technically make your annual contribution up to the tax deadline of the following year. In other words, you have until April 15, 2020 to reach your maximum contribution for 2019.
However, you can’t contribute the maximum amount if your income breaches a certain limit. And there’s also a cut off when you can’t contribute anything toward this plan at all. We’ll break all of this down for you.
In order for an individual taxpayer to qualify for investing in a Coverdell ESA, his or her modified adjusted gross income (MAGI) can’t be more than $110,000. The income limit for married couples contributing jointly is $220,000.
But there are also phase-out points. This means your contribution limits go down from the annual $2,000 once your income passes a certain point.
In order to make the maximum contribution as an individual taxpayer, your income can’t exceed $95,000. Afterward, your contribution limit dips before it disappears altogether as described above. For married couples to contribute the maximum amount, their combined modified adjusted gross income (MAGI) can’t go past $190,000. Their contribution limits begin to fall here in the same fashion.
But if you’re comfortable with these income rules, a Coverdell ESA may be right for you.What Does a Coverdell ESA Cover?
A Coverdell ESA covers a bit more territory when it comes to what you can use your funds on without incurring taxes.
Your withdrawals from a Coverdell ESA are tax-free as long as you use them on qualified elementary and secondary education expenses or qualified higher education expenses. A 529 plan covers the latter and elementary school expenses to a limited extent.
However, you can take money from your Coverdell ESA tax-free to cover your child’s high school tutoring bills if you need. This is one of the benefits that make Coverdell ESAs effective in helping parents pay down tuition at private high schools and similar expenses.
Below is a breakdown of what you can safely use your Coverdell ESA funds at primary, secondary and higher educational institutions:
You can find detailed information on what you can use Coverdell ESA distributions without incurring taxes by reading IRS publication 970: Tax Benefits for Education.
But the rule of thumb is to avoid using that money on anything that’s not “qualified.” If you do, the earnings portion of your non-qualified withdrawal would face income tax at your rate and a 10% penalty. State taxes may apply as well. Seek a qualified financial advisor and tax professional for more comprehensive details on how Coverdell ESA withdrawals are treated for tax purposes.How Does a Coverdell ESA Affect Financial Aid?
Contrary to popular belief, opening a Coverdell ESA or a 529 plan won’t shoot down your child’s chances of getting a financial aid package. Only a certain portion of the balance would be considered depending on who owns the account.
Overall, it’s best to keep it in the name of the legal parent or beneficiary. In either case, up to 5.64% of the Coverdell ESA’s value would be factored into the student’s expected family contribution (EFC) on the Free Application for Federal Student Aid (FAFSA). The EFC helps determine how much aid would be awarded to the student. The smaller the EFC, the better.
If a grandparent opens a Coverdell ESA for a grandchild, however, the rules shift. In this case, the amount withdrawn gets added into the student’s income for next year’s FAFSA. Up to 50% of a student’s income can be factored into the EFC.
So if a grandparent withdrew $20,000 to cover a grandchild’s qualified educational expenses, that student’s EFC will hike up to an additional $10,000 on his or her next FAFSA.
All other factors equal, a student would generally get a smaller financial aid package if a grandparent opened a Coverdell ESA in his or her name, as opposed to a parent.Disadvantages of a Coverdell ESA
Despite its benefits, a Coverdell ESA has its drawbacks. Its annual contribution maximum pales in comparison to 529 plan limits. The contribution limit for Coverdell ESAs stick at $2,000 per student. This means that if a parent and grandparent each opened a Coverdell ESA for one child, the total of both accounts can’t exceed $2,000.
529 plan contribution limits vary by state, but they range from around $200,000 to $500,000 per student.
And not everyone can even contribute toward a Coverdell ESA. Remember, Coverdell ESAs have income requirements. But any U.S. citizen can contribute toward a 529 plan regardless of income status.
Coverdell ESAs also place age limits on your beneficiary. You can contribute toward this plan until your child reaches age 18. Otherwise, these additional contributions would be subject to a 6% excise tax. Furthermore, you have to deplete your balance by the time the beneficiary reaches age 30. Failure to do so would trigger a 10% penalty tax on the earnings portion of what’s left in addition to regular income tax.
With a 529 plan, however, you can contribute for as long as you want regardless of your child’s age. But if your child doesn’t go to college by the time he or she turns 18, you can roll over your Coverdell ESA balance into a 529 plan for that beneficiary.
In addition, contributions toward a Coverdell ESA aren’t tax deductible. On the other hand, some states allow certain tax-deductions or credits based on your 529 plan contributions.Can I Open a Coverdell ESA and a 529 Plan?
Are you comparing 529 plans and Coverdell ESAs? No law prevents you from getting the best of both worlds. You can open a 529 plan and Coverdell ESA to save for your child’s educational expenses. This move might make sense if you need extra money to cover primary or secondary education expenses. You can keep investing toward your child’s college education using the Coverdell ESA until he or she turns 18, and then roll over what’s left into your 529 plan.
Plus, you can take advantage of tax deductions or credits your state may allow. But if it doesn’t, you may want to max out your Coverdell ESA contributions before contributing toward the 529 plan.The Takeaway
A Coverdell ESA offers several benefits, but it also has some disadvantages. In order to contribute, your income can’t pass a certain level. Income limits also prevent you from contributing the maximum. In addition, the maximum contribution of $2,000 a year dips sharply in comparison to limits tied to 529 plans. However, Coverdell ESAs let you make tax-free withdraws to cover several educational expenses from elementary to high school. This is a perk the 529 plan falls short in. A Coverdell ESA also gives you access to virtually the entire investment world, while a 529 plan and other savings vehicles limit you to specific fund menus. Ultimately, your personal needs and savings goals should determine whether a Coverdell ESA is right for you.Tips on Saving for College
The post Saving for College With a Coverdell ESA: Weighing the Pros and Cons appeared first on SmartAsset Blog.
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