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 Non-qualified withdrawals might be taxed, while money withdrawn for qualified educational expenses won’t be taxed.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. 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.
Who Can Invest In 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 collegeForesight in planning for college early in their beneficiary’s lifeAspiration to save a large, lump sumBeneficiary(s) attend private elementary or secondary schoolsDemand a high level of flexibility with investment choicesIncome below the maximum limits for contributors ($110,000 for single filers, $220,000 for married couples in 2021)
Advantages and Disadvantages of a Coverdell ESA
Just like any other investment, there are benefits and drawbacks of putting money away in a Coverdell ESA.
Advantages of a Coverdell ESA
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.
Disadvantages of a Coverdell ESA
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.
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, however, be taxed.
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 amount 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.
Contribution and Withdrawal Rules For a Coverdell ESA
In addition to the modified adjusted gross income limits, there are a number of rules you need to keep in mind while putting money into and taking money out of 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 the tax day of the following year to make a contribution for the previous tax year, even if you file an extension with the IRS.
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.
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.
