What is a Coverdell ESA? A savings account that is set up to pay the qualified education expenses of a designated beneficiary.
Where can it be established? It can be opened in the United States at any bank or other IRS-approved entity that offers Coverdell ESAs.
Who can have a Coverdell ESA? Any beneficiary who is under age 18 or is a special needs beneficiary.
Who can contribute to a Coverdell ESA? Generally, any individual (including the beneficiary) whose modified adjusted gross income for the year is less than $110,000 ($220,000 in the case of a joint return).
Are distributions tax free? Yes, if the distributions are not more than the beneficiary’s adjusted qualified education expenses for the year.
This benefit applies not only to higher education expenses, but also to elementary and secondary education expenses. Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed.
If, for a year, distributions from an account are not more than a designated beneficiary’s qualified education expenses at an eligible educational institution, the beneficiary will not owe tax on the distributions. See Tax-Free Distributions
- You don’t have to fund it with millions of dollars. One of the frustrating things about college savings plans is that the end goal feels so unreachable for many families and it can be overwhelming to figuring where to start. Coverdell ESAs do not have statutory minimums. You can contribute as little to the plan as the administrator will allow: both TD Ameritrade and Gabelli Funds offer plans with no minimum account balance while USAA has a minimum of just $50.
- You can skip contributions. With a traditional IRA, many taxpayers rely on regular contributions taken out of their paychecks. But with a Coverdell, you make contributions on your own time. They don’t have to be regular or timed – and you can skip a year or two if you want.
- Coverdell ESA caps are low. One of the worries with some plans is that you’ll overfund the plans and be subject to penalties later if you don’t use all of the funds. Fortunately, the maximum contribution rate for Coverdell ESAs tops out at just $2,000 (though phase outs apply). If you go over the $2,000 cap, the extra contribution portion is subject to a 6% excise tax penalty.
- You don’t have to make the contribution yourself. A grandparent or other person can make the contribution but the caps still apply (see #3). If you’re over the income limit, your child can even make the contribution (yes, it’s okay to gift the money). Unlike an IRA, there is no requirement that the contributor have earned income.
- The money grows tax free. The big draw of the plan – and why it was originally termed an IRA – is that money you contribute to the plan grows federal income tax free.
- The money comes out tax free. Assuming that you follow the rules, funds can be withdrawn from the plan and used for qualifying education expenses – and it won’t cost you a penny in federal income tax.
- You have a wide variety of investment options. Unlike some other plans that restrict your ability to pick and choose, you can invest your Coverdell ESA however you like – assuming your administrator makes it available.
- Tax-free withdrawals won’t affect many financial aid applications. So long as the funds in the plan are used for qualifying educational expenses, the withdrawals are federal income tax free and may need not to be reported for some financial aid purposes.
- Special considerations exist for special needs. While contributions are not allowed after age 18 for most students, contributions are permitted after age 18 for special needs children. This allows you to continue to save for tutors and other needs.
- You don’t have to use the funds for college! This is the best part. The plan can be used to pay tuition and other expenses for students in kindergarten through 12th grade, college or trade school. It doesn’t matter if it’s public, private or parochial.
But be careful:
- Contributions are not tax deductible for federal income tax purposes.
- You can’t double-dip. You may not use funds withdrawn from the plan to pay for expenses that you hope to claim later for another education tax break like the American Opportunity Tax Credit, Lifetime Learning Credit or the tuition and fees deduction.
- The funds must be reached by the time the beneficiary turns 30. The account can, however, be transferred to a relative. If the balance is not withdrawn or transferred, the earnings are taxable for federal purposes and are also subject to a 10% penalty.
So what kind of expenses count? Clearly, tuition and fees as well as books, supplies, and equipment. Expenses also may include academic tutoring; special needs services; room and board; uniforms; and transportation.
Even better? The purchase of computer technology, equipment, or internet access is specifically deemed a qualifying expense if used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school.