Is A Coverdell ESA Right For You?

Is A Coverdell ESA Right For You?

Is A Coverdell ESA Right For You?

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.

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Coverdell ESA Eligibility

Contributions to these accounts are limited by modified adjusted gross income (MAGI). The maximum income for joint and single tax filers is $190,000 and $95,000 respectively. For incomes beyond those amounts, contributions are reduced. For joint and single modified AGI beyond $220,000 and $110,00 respectively, no contribution is allowed. View the tables below for details on determining how much you can contribute.

Coverdell ESA - Joint MAGI $200,000

Coverdell ESA – Joint MAGI $200,000

Coverdell ESA - SINGLE MAGI $100,000

Coverdell ESA – SINGLE MAGI $100,000

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.

A beneficiary of a Coverdell ESA must be age 18 or less. However, if the beneficiary is a “special needs beneficiary, the age requirement does not apply. In addition, there is no relationship requirement for contributions so you can set these up for multiple beneficiaries. As long as the contribution to each does not exceed $2,000 (or reduced limit based on income) and you adhere to the age limit rules, you should be in the clear.

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Converdell ESA Tax Considerations:

It is important to be mindful of the limits on contributions because the penalties for over-contributing can be significant. A 6 percent tax can be incurred on amounts that exceed the allowable contributions. In addition, that 6 percent penalty can be assessed each year the excess contribution remains in the account.

When you make contributions to a Coverdell ESA, there is no deduction allowed. While the funds are invested, there is no tax on capital gains or dividends and interest. This is known as “tax-deferred earnings.” If the funds are used to pay for qualified education expenses, the withdrawals will be tax free. For more information on the difference between these, please review my article titled TAX-DEFERRED VS TAX-FREE INVESTMENT ACCOUNTS.

Qualified Education Expenses:

Be mindful that qualified education expenses are reduced by amounts used for American Opportunity Credit or LIfetime Learning Credit.

Expenses must be incurred in an eligible educational institution. These include college, vocational school, university, other elementary, secondary, or post secondary institution.

Qualified education expenses are amounts paid for tuition, fees and other related expenses for an eligible student.

Coverdell ESA - Qualified Education Expenses

Coverdell ESA – Qualified Education Expenses

Source: WebCE, Inc. Individual Retirement Accounts

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.

Is a Coverdell ESA right for you?

Is a Coverdell ESA right for you?

Coverdell ESA -What if the beneficiary decides not to go to school?

There is always a possibility that an individual will choose not to go to school or further their education. Funds must generally be used by age 30. Whatever funds are not used within 30 days of the beneficiary turning 30 will be considered distributed and taxes will apply. However, there is an opportunity to rollover Coverdell ESA funds to another beneficiary so long as that person is a member of the original beneficiary’s family.

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. Many people are turned off by the low annual limit of $2,000 and no immediate tax benefit via reduction in taxable income. Make no mistake, a little bit over a long period of time adds up to a lot!

The Coverdell ESA is often overshadowed by the mighty 529 college savings plan. After all, 529s allow for very sizable contributions. So high, in fact, that most people will never reach the annual limit. But, we are all so focused on saving for college that we forget about education needs prior to that. Coverdell ESAs can help bridge the gap.

Do you have questions about the Coverdell ESA?

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