Coverdell Educational Savings Account (ESA) – Guide

Coverdell Educational Savings Account (ESA) offers tax savings. Also, help you to manage how and where you invest your contributions.  Because of that,  this educational saving account represents a great way to save for your child’s college education.

Coverdell Educational Savings Account (ESA was originally introduced in 1997 as the Education IRA. Also known as an ESA,  Education Savings Account, a Coverdell ESA, a Coverdell Account, and formerly known as an education individual retirement account. In 2001, Congress renamed it the Coverdell Educational Savings Account (ESA) and expanded its benefits.

History of ESA?

Back when it was the Education IRA, not too much (despite the lure of tax-free income). In 2002, however, the re-named Coverdell education savings account became a very attractive college savings vehicle for many people, including families that wish to save for elementary and secondary school expenses as certain K-12 expenses were added to the list of qualified expenses. In fact, even if you like the 529 plan you may still decide to contribute the first $2,000 of savings for each child into a Coverdell Educational Savings Account. There are some items to be aware of, however, such as the following:

 Advantages and disadvantages 

  1. You can only contribute $2,000 annually to a Coverdell.
  2. There are income limits for Coverdell Educational Savings Account.
  3. Contributions aren’t allowed to Coverdell Educational Savings Account for beneficiaries over 18 and a beneficiary can’t be over 30
  4. Coverdells can be used for elementary and secondary school expenses
  5. You can choose virtually any investment for a Coverdell
  6. The relatively low contribution limit means that even a small annual maintenance fee charged by the financial institution holding your ESA could significantly affect your overall investment return.
  7. tax law prohibits ESA funding once the beneficiary reaches age 18.
  8. If total contributions exceed $2,000 in a year, a penalty will be owed.
  9. Your contribution goes into an account that will eventually be distributed to your child if not used for college. The refundacion process is not simple like with most 529 plans. This means you lose some degree of control.
  10. The ESA is on equal footing with the 529 plan when applying for federal financial aid.
  11. The account is considered an asset of the account custodian, typically the parent. Withdrawals are tax-free for federal income taxes and will not be reported as a student or parent income.
  12. The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties.
  13. You can contribute to both a 529 plan and an Coverdell Educational Savings Account for the same beneficiary if you wish.
  14. There are certain eligibility requirements in the year you wish to contribute to the ESA, which means that not everyone will find them useful. When a beneficiary turns 18, he can no longer use ESA, because it is forbidden by law
  15. In 2002, the contribution limit was increased from $500 per child to the much more reasonable level of $2,000. However, you need to be careful when accounts are established by different family members for the same child. If total contributions exceed $2,000 in a year, a penalty will be owed.
  16. Low contribution limit implies that even a small annual maintenance fee charged by the financial institution holding your ESA might considerably have an effect on your overall investment return.
  17. Your contribution goes into an account that will eventually be distributed to your child if not used for college. You cannot simply refund the account back to yourself like you can with most 529 plans. This means you lose some degree of control.
  18. The Coverdell Educational Savings Account is on equal footing with the 529 plan when applying for federal financial aid. The account is considered an asset of the account custodian, typically the parent.
  19. Coordinating withdrawals with other tax benefits especially can be tricky.
  20. The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties.

So how Coverdell Educational Savings Account work?

ESA,  an investment targeted to education expenses, allow you to make an annual non-deductible contribution to a specially designated trust account. You will need to meet certain requirements, your account will grow free of federal income taxes, and withdrawals from the account will be completely tax-free as well. You may save even more if you live in a state that imposes an income tax.

But be aware that the tax law will not allow you to “double-dip” by claiming multiple tax breaks for the same expense.

To be qualified to establish a Coverdell Educational Savings Account (ESA) account, you need to be under the age of 18 at the time of the contribution.The beneficiary doesn’t need to be your child or have any other particular relationship.

There are certain requirements related to your income: contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution

When you are sure that you meet the criteria, you can decide where to establish the Coverdell Educational Savings Account (ESA).

Any financial institution like a bank or mutual funds or other that can serve as custodian of traditional IRAs is capable of serving as custodian of an ESA. Your contribution can be invested in any qualifying investments available through the sponsoring institution, except in life insurance.

There is no limit to the number of Coverdell Educational Savings Accounts that you can establish for any one child. But the total contributions stay within the $2,000 limit.

Next step is to complete the ESA enrollment forms from the sponsor, including the designation of a beneficiary and make the contribution.

How do I establish an Coverdell Educational Savings Account?

When you checked whether you are eligible to contribute to an ESA.

The beneficiary of the account must be under the age of 18 at the time of the contribution.

The beneficiary doesn’t have to be your child or have any other particular relationship.

Also, your income must be below a certain level in the year of your contribution.

Contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution.

If your modified adjusted gross income falls between $190,000 and $220,000 ($95,000 and $110,000 for single filers),the $2,000 maximum is gradually phased out.

To open Coverdell ESA  account, you need:

SSN of the beneficiary and other personal information, including name, date of birth, address, and possibly other information, depending on where you open the account.

Where Should You Open Your Coverdell ESA?

You can open a Coverdell Education Savings Accounts (ESA) plan on different locations.

Any financial institution like mutual fund houses, banks, credit unions, and other options can serve as custodian of traditional IRAs is capable of serving as custodian of an ESA. Your contribution can be invested in many qualifying investments through the sponsoring institution. You may find it best to work with the investment firm that handles most of your current investments, or you may find it better to work with a new company if they offer better rates or investment options.

Be smart!

Research these options before investing with them. Many of these financial institutions do not offer as many investment options, and they may have slightly higher fees than you can find at some of the largest investment firms.

Also, there is no limit to the number of ESAs that you can establish for any one child (as long as the total contributions stay within the $2,000 limit)

If your income is above the allowable limit, your child can make the contribution!

You can simply gift the money to the child, and then your child can make the  ESA contribution. There is no requirement that the contributor has earned income.

Changes to the Coverdell Educational Savings Account (ESA)

If your child decides not to attend college

The responsible individual on the account can change the beneficiary at any time to another qualifying family member who has not yet attained the age of 30, subject to any restrictions imposed by the donor at the time the account is established. The new beneficiary must be under age 30 at the time of rollover.

If you want to move the assets from the ESA to a different financial institution

You may take a rollover distribution from an existing ESA without triggering tax or penalty, If you, within 60 days, make a  deposit to a different ESA for the same beneficiary or for any other qualifying member of the family. This 60-day rollover may be accomplished only once in a 12-month period.

 

You can move the funds from your child’s ESA into a 529 plan!

If you decide that 529 plan suits you more you can withdraw funds from an ESA. This fund is tax-free for contributions that made to a 529 account for the same beneficiary in the same taxable year. You have to look at all the options that you have and decide for the best ones!  Your choice of approach may also have different gift tax ramifications.

Limit to Coverdell ESA contributions?

The annual contribution limit maximum is $2,000 per beneficiary.

Contributors

Parents, grandparents, other relatives, friends, even a child for whom the account is being established can contribute to a Coverdell ESA. Also, organizations, such as corporations, can invest in a Coverdell ESA. Individuals or organizations can make contributions.

Understand the effect of your saving on financial aid eligibility

If you wandering does the ESA have an impact on your financial aid eligibility, the answer is yes. The truth is that Coverdell ESA does have a negative effect on aid eligibility. The good news that the effect is minimal compared to other accounts.

Up to 5.64 percent of the value of a Coverdell ESA (just like a 529 plan) owned by a parent or student will be included in the student’s Expected Family Contribution (EFC). Withdrawals taken from parent- or student-owned accounts will be excluded from your federal income tax return.

In case that grandparent or other relative owns the account, nothing will have to be reported until the funds are withdrawn. Also in this case withdrawal will be “added back” and counted as student income on the following year’s FAFSA. Student income is assessed at up to 50 percent. That means if a grandparent takes out $20,000 to pay for a grandchild’s college, that grandchild’s EFC will be increased by $10,000.

Notice: higher EFC means less financial aid!

Tax treatment of Coverdell Educational Savings Account (ESA) contributions and earnings

Coverdell Education Savings Accounts contributions are not tax deductible. Just like a Roth IRA, amounts deposited in the accounts grow tax-free until withdrawn. If the funds are intended for education or education-related costs withdrawals from Coverdell ESA are tax-free.

How can Coverdell ESA withdrawals be used?

ESA funds can be used for education expenses and for any educational institution eligible to participate in a student aid program administered by the Department of Education.  This includes elementary and secondary schools (K-12), including public, private, or religious schools, as well as any college, university, vocational school, or other postsecondary educational institution

What expenses are covered by Coverdell ESA?

Coverdell ESAs can be used only to pay for qualified education expenses. This includes the cost of books, supplies and other equipment; and sometimes the cost of room and board. Elementary and secondary school expenses include expenses for tuition, fees, books, supplies and other equipment; computer technology, equipment,  Internet access; special needs services in the case of a special needs beneficiary;  and, in some cases, room and board, uniforms, transportation, and extended day programs.

When can Coverdell ESA assets be withdrawn?

You can make distributions at any time. It will generally not be considered taxable income for the beneficiary if the distribution is applied to the payment of the qualified education expenses. ESA funds must be used before the student reaches the age of 30 years. Otherwise, the earnings portion will be considered as taxable income of the beneficiary. To avoid this situation, the funds from the Coverdell Educational Savings Account may be rolled over into a Coverdell ESA for another eligible family member before the primary beneficiary reaches age 30.