Understanding the Coverdell ESA College Savings Account

A Coverdell Education Savings Account is a savings vehicle designed to provide tax-free savings for a child’s education. Learn how a Coverdell ESA works and how it compares to a 529 savings plan.

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You Need to Understand This When Paying for College!

Understanding the Coverdell ESA College Savings Account

A four-year college degree in the US costs approximately $122,000. Of course, if a student takes over four years, the cost will be higher than that. No parent wants to have to fork out about $30,500 a year for college without having planned for it. Parents who want an early start in paying for their children's education have many options at their disposal. One of these options is the Coverdell ESA (Education Savings Account).

What is a Coverdell ESA?

A Coverdell ESA (Education Savings Account) is a special account created by the US government to help families save up to pay for their children's future education. The Coverdell ESA has two main parties: The owner (parent or guardian), who opens, manages and contributes to the account, and the beneficiary (the child), who receives distributions from the account. In some cases, the parent can open an account but have their child own it. A member of the extended family, like a grandparent, and even a non-relative, can also open an ESA account for the child. And contribute to it too. Additionally, a child can have more than one Coverdell ESA account opened for them by different people.

ESA accounts are different from bank savings accounts because, unlike bank accounts that can only hold cash, ESAs can hold both cash and investment securities like bonds, stocks, and mutual funds. So an ESA can act both as a savings account and an investment account. However, an ESA cannot invest in real estate, personal business, precious metals, or collectibles. Bank accounts are also insured, whereas ESAs are not.

Coverdell ESA accounts are tax-deferred. Any investment income or growth in the account isn't taxed until you withdraw the funds. This allows you to potentially grow your investments faster because they will not incur tax as the compound interest grows. In a traditional investment, these earnings would incur capital gains tax, which would reduce your income.

What Are The Requirements For Opening A Coverdell ESA Account?

  • The account must be designated as a Coverdell ESA when opened.
  • The beneficiary of the account must be 18 years of age or below.
  • Exceptions can be made for beneficiaries above 18 years of age if they have special needs.
  • The document that creates the account must meet the existing IRS requirements and must be in writing.

What are the Contribution Limits?

For a beneficiary, you may have more than one Coverdell account, but the combined annual contribution to all accounts cannot exceed $2,000 per beneficiary. You can contribute to an ESA each year up until the tax filing deadline for that year, just like with individual retirement accounts. Who is eligible to open a Coverdell account is subject to income restrictions, which are determined by your modified adjusted growth income and filing status.

If you jointly file your taxes and your MAGI is less than $190,000 ($95,000 for single filers), you are qualified to make the full contribution. The maximum amount that can be contributed by those with higher MAGI will be decreased.

Additionally, you are not permitted to make contributions to a Coverdell ESA if your MAGI exceeds $220,000 ($110,000 for single filers) annually.

What are the Distributions of a Coverdell ESA?

The beneficiary of a Coverdell ESA can typically withdraw funds tax-free from the account as long as they are used for eligible educational costs. The selection of what is acceptable is fairly wide: Tuition, books and supplies, tutoring, and occasionally travel or lodging, can all be paid for with the help of financial aid. It's critical to know whether an expense will be regarded as qualified before taking a distribution because nonqualified distributions are subject to taxation to the beneficiary and a 10% penalty.

In order to avoid making a costly mistake, you might want to speak with a tax advisor if you're not sure whether a distribution satisfies the requirements. When the beneficiary of a Coverdell ESA reaches age 30, any remaining funds must be distributed (again, there are exceptions if the beneficiary has special needs). The beneficiary of the account would be subject to taxes and a 10% penalty if the distribution at age 30 did not qualify as an educational expense. However, you can designate a different family member as the beneficiary of a Coverdell account once per year.

Expenses Covered By a Coverdell ESA

Withdrawals made from an ESA account do not incur federal taxes as long as they are used for qualified education expenses. These include:

  1. Tuition fees.
  2. Accommodation expenses
  3. Computers and internet services
  4. Books and supplies
  5. Uniforms
  6. Transportation

Coverdell ESA account funds can also be used to pay for elementary and secondary educational needs. That money can also cover private or public, religious or secular schools, and post-secondary institutions that qualify for government financial aid.

Rules Governing Coverdell ESAs

  • A contributor can only put a maximum of $2,000 in after-tax contributions per year to the ESA account. This means that if your relatives decide to help you out with your kid's education fund and contribute $1,000, you can only provide $1,000 that year.
  • Parents can only contribute to a child's Coverdell account until they turn 18 unless they have special needs.
  • A child can have more than one ESA opened by different members of their family. However, the contributions must not be more than $2,000 across all the accounts TOTAL that year.
  • The amount of contributions made depends on the Modified Adjusted Gross Income (MAGI) of the contributors. Single tax filers with a MAGI of less than $95,000 or joint filers with a MAGI of less than $190, 000 can contribute the full $2,000.
  • Single filers with a MAGI of between $95,000 and $110,000 or joint filers with a MAGI of $190,000 to $220,000 can make a partial contribution.
  • Single filers with a MAGI of over $110,000 or joint filers with a MAGI of over $220,000 cannot contribute.
  • Corporations and trusts can also make contributions and are not subject to the adjusted gross income restrictions.
  • You must make your ESA contribution for the previous year by the date of your tax- filing deadline, even if you have an extension.
  • Withdrawals from the ESA are not taxed unless they exceed the actual amount of qualified expenses. Remember the costs we mentioned earlier? Those are tax-free, but funds above that are subject to taxation and penalties.
  • The beneficiary must use or transfer the ESA money by the age of 30. However, if the recipient has special needs, the funds can be left for a more extended time-period after consulting the relevant authorities.

Advantages of Coverdell ESAs

  • Funds in Coverdell ESAs can be grown through tax-deferred investments in stocks, bonds, and mutual bonds.
  • Withdrawals for the purpose of funding education are not taxed.
  • The beneficiary of an ESA can be changed to another family member once a year.
  • Money that is still unused when the beneficiary turns 30 years old can be transferred to another eligible family member and does not go to waste.

Disadvantages of Coverdell ESAs

  • The ESA Funds must be used by the time the beneficiary reaches 30 years of age, or they have to be withdrawn and incur a 10% penalty.
  • Withdrawal of funds for non-qualified expenses incurs a federal penalty of 10% and taxation.
  • Coverdell ESAs lowers the amount of financial aid a student receives, so in a way, they save the federal government expenditure in financial aid.

Am I Eligibility for a Coverdell ESA?

In order to open a Coverdell ESA, you must be under the age of 18 at the time of account opening, and the funds must be distributed to you when you turn 30 years old in order to be eligible. 529 plans, in contrast to ESAs, do not impose any limitations on contributions based on the owner's age.

There is no age limit for the beneficiary of a 529 plan, and funds can be used whenever they are needed. You may not be able to open or contribute to a Coverdell ESA if your income exceeds a certain threshold. It's possible for higher earners to open a 529 plan instead, which does not have an income limit on contributions, for tax-deferred savings toward higher education.

Does a Coverdell ESA Affect Financial Aid Eligibility?

A Coverdell ESA is like a cash asset and will affect your child's eligibility for financial aid. This is because students are required to contribute 20% of their financial assets to education expenses. Ownership of Coverdell accounts, therefore, matters, as you can see below:

  1. If the child is both the owner and the beneficiary of the account and is dependent on the parents, the assets in the ESA will be counted against financial aid  
  2. If the child is both the owner and the beneficiary of the account but is independent of the parents, 20% of the assets in the account will be counted against financial aid.
  3. If the parent is the owner of the account, 5.64% of the assets will be counted against financial aid, so the child will get more aid than in the circumstances above.
  4. If the ESA owner is a member of the extended family or an unrelated individual, the assets will not be counted against financial aid.

Common Mistakes Made With Coverdell ESAs

Here are some common mistakes you want to avoid with your Coverdell ESAs Account:

1. Saving Too Little

You can only contribute a maximum of $2,000 to a Coverdell account per year. This will not cover all educational expenses, so you have to consider additional ways of saving to top up the rest of the amount needed.

2. Saving Past 18 Years of Age

Coverdell ESA contributions should only be made for beneficiaries who are 18 years and younger. Deposits made after that are subject to an excise tax of 6%, so by continuing to make contributions, you will be losing money, not saving up.

3. Failure to Use the Funds by 30 Years of Age

Funds left in an ESA account after the child turns 30 incur income tax plus a 10% penalty. If your child changes their mind and decides not to go to college, don't let that happen. Take the money out or transfer it to another child's ESA.

4. Failure to Understand the Effect on Financial Aid Eligibility

As mentioned earlier, having a Coverdell ESA can affect how much your child will get for financial aid. Parents opening ESAs for their children sometimes do not consider this and make the wrong decision regarding ownership, which affects the child's eligibility for financial aid. Coverdell ESAs cannot pay for all educational expenses, so make sure you don't hurt your child's chances of getting enough financial support to get them through school.

5. Spending Withdrawals on Non-qualified Education Expenses

Withdrawals are only tax-free when they are used to pay for qualified educational expenses. Any earnings from withdrawals used for non-educational purposes will be taxed and incur a penalty. Both the owners and beneficiaries of ESAs should never forget this.

6. Starting Late

Since funds in an ESA earn interest, the earlier you open the account and start saving, the better. Starting late will reduce the amount of time you have to grow your investments, and you won't have saved much to help you pay for your child's college expenses

Should I get a Coverdell ESA?

Depending on how much money you have, opening a Coverdell ESA could be a good idea for you and your family.

If you want to save for college without paying taxes and have more options for how to invest your money, a Coverdell might be right for you. If you want to save more than $2,000 per year for college, you might want to open a 529 plan instead of a Coverdell or in addition to it. Before choosing the best option for you, it's always best to talk to a tax professional or financial advisor.

Wrapping Up

Paying for your children's college education doesn't have to be a headache. As soon as you can, start saving for it, and with a Coverdell ESA, you'll be saving and investing as well. It's a win-win situation that you can't miss out on. Consider the points discussed in this post to find the best saving plan for your child and have peace of mind when they finally go to college.

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