Is a Coverdell ESA right for you? With so many ways to save for future education costs, it’s hard to know which accounts to use. The first thing to realize is that the various accounts out there are not in competition with each other. In fact, they compliment each other.
There are important differences between these accounts, but rather than trying to identify which one is best, it is important to focus on which one is right for you. Many times the answer is a combination rather than one over the other.
The Coverdell ESA (Education Savings Account) can play a role in your education savings plan and should not be ignored. The most important characteristic of the ESA is that while it can be used for college, it isn’t limited to college expenses like the 529 College Savings Plan. This means you can use the funds for qualified education expenses incurred for K-12.
A Coverdell ESA allows you to save for education expenses similar to how you save for retirement in a Roth IRA. You won’t get a tax deduction for amounts you contribute but your withdrawals for qualified education expenses are tax free. The taxation is also similar to the 529.
Is A Coverdell ESA Right For You?
If your children are very young and have several years until college, you may want to start your savings plan with an ESA. The primary reason is that it gives you an option to use the funds for K-12 expenses. Lets assume your child is 2 years old and you want to open an account to start saving for college. After all, the rising cost of college is usually what is top of mind. If you start with an ESA, you could access these funds for expenses related to K-12 if and when the need arises. Funds in a 529 can only be used for college expenses. By starting with an ESA, you are giving yourself greater flexibility to fund education expenses prior to college.
If you are getting aggressive early with your savings plan you will quickly max out your contribution to the ESA because the annual limit is $2,000. There are also income limits that need to be considered because you may not be eligible to contribute. The good news is that you can have both an ESA and 529 plan at the same time. One strategy to consider is to fund an ESA up to the $2,000 limit and then contribute additional funds to a 529 plan.
As with all investment accounts, there are important income, gift, and estate tax considerations most of which have not been detailed here. However, if you’re looking to get started with an education savings plan, don’t over look Coverdell ESAs. They can play an important role in your education savings plan.