Taking the Covers Off the Coverdell ESA
As parents of college bound children, you may have heard of the 529 plan. It’s a tax-advantaged investment intended to help you save for your child’s education. Although 529s may be the most familiar mechanisms for saving, they are not the only vehicles the government has created for this purpose. Enter the Coverdell Education Savings Account, or Coverdell ESA. It’s an investment account that acts as an incentive to help parents and students save for education expenses. But the key point with these investments is that the money saved can be used at any educational institution.
Distributing the Savings
When it comes time to take money out of a Coverdell ESA, parents have a number of options. First of all, any distributions are tax-free if they’re used for qualified education expenses. This would include tuition and fees, supplies, books, room and board, etc. In addition, Coverdell ESA distributions can be utilized for any public, private, or religious school, secondary or elementary school, colleges, universities, post-secondary schools, and vocational schools.
If the money you save and withdraw from the ESA is more than what you need, it will be subject to tax. And if your child reaches 30 years old and still holds a balance in a Coverdell ESA, it must be distributed within 30 days. Or the savings can be rolled over to another ESA for another family member. Another important element of these investments is that they are not considered parent or student income and do not reduce financial aid eligibility.
Contributing to Coverdells
Your contributions to a Coverdell ESA cannot exceed $2,000 per year. These contributions are not deductible and there are limits based on the contributor’s Modified Adjusted Gross Income. In other words, the $2,000 per year figure changes depending on the amount of money a parent makes. Joint filers making between $190,000 and $220,000 would only be able to make a partial contribution and not the maximum of $2,000.
What’s the Difference?
If you’re familiar with 529 plans and you’re wondering what the major differences are between those investments and Coverdell ESAs, read on. For one thing, Coverdell ESA allows investments in a greater variety of vehicles (stocks, bonds, etc). 529 plans keep you within a state’s individual program. Although there are contribution limits with ESAs, 529s only have a maximum lifetime contribution limit. And as we stated above, ESAs must be distributed by the time the beneficiary turns 30. 529s have no age limit. The last and most striking difference between these two programs relates to how you will spend the money you save. 529s are intended for college only, but Coverdell ESAs have the advantage of being used for any qualified school expenses, from elementary school to post-graduate work.
Making a Choice
If you’re struggling to decide what program best fits your needs, consider that you can choose both Coverdell ESAs and 529s. The Economic Growth and Tax Relief Reconciliation Act of 2001 ensures that parents can open up an ESA and 529 for the same beneficiary and can contribute to both in the same year. This could be an ideal situation for parents who want to diversify their investments, have opened a prepaid tuition 529 and want to save for room and board, or have children who will be attending private elementary or secondary school and are unsure if there will be enough money left over to allocate to college. If you do choose this option, you’ll want to consult with a financial professional to make sure you use the distributions for qualified education expenses. As for their impact on financial aid eligibility, it will depend on the account owner, the beneficiary, and whether the student is considered dependent or independent. The legislation surrounding these vehicles changes frequently so we strongly recommend you check with a financial aid officer or visit the IRS Web site for more detailed information.
