A Coverdell Education Savings Account, also known simply as a Coverdell ESA, is a trust account established by the government to help families pay for qualified education expenses. A Coverdell ESA can be opened up for anyone who is age 18 or younger. However, the assets held in the plan must be withdrawn when the beneficiary has reached the age of 30. If the beneficiary has special needs, these age restrictions may be waived. Funds in the plan can go towards K-12 primary and secondary schools, in addition to higher education. The funds can be used towards many important education expenses, such as books and tuition.
How Does the Coverdell ESA Work?
A Coverdell ESA can be set up for all qualified beneficiaries. For example, if you have a son and daughter, ages 4 and 6, an ESA can be set up for each child. Unlike traditional retirement plans, such as an IRA or 401(k), contributions made to a Coverdell are not tax deductible. However, all withdrawals that are used to pay for qualified education expenses are tax-free. Any distributions from the account not used for educational expenses will be taxed at the beneficiary’s current tax rate. Generally, this is a lower tax rate than that of the contributor.
Funds in the plan are invested based on the contributor’s discretion. If the Coverdell ESA is opened at a traditional financial institution, your investments will be limited. Typically, you can only invest in traditional assets, such as stocks, bonds and mutual funds. However, if you self-direct your ESA with IRA Financial, you can also invest in alternative asset investments, such as real estate and precious metals.
No matter which route you choose, your investments will grow on a tax-free basis. Instead of paying taxes annually on you holdings, the funds are shielded and are only paid on non-qualified withdrawals. For example, if you invest $10,000 and it grows to $50,000, the entire amount would be tax free if used on education expenses.
What Are the Contribution Limits?
For 2020, you may contribute up to $2,000 for each of your beneficiaries. Again, if you have to eligible children, you may contribute up to $2,000 for each child, every year until he or she reach age 18. Further, unlike many other plans, other people may also contribute on your behalf. This may include grandparents and other relatives, friends, businesses and the beneficiary him/herself. However, no matter who contributes, you cannot exceed the annual limit. There are income restriction for who can contribute to an ESA. You may contribute if your income is less than $110,000 as a single filer or $220,000 for those filing a joint return. In addition, organizations, such as corporations, can help fund the plan.
If you start funding a Coverdell ESA as soon as your child is born, you may contribute approximately $36,000 to the plan. This is assuming the $2,000 annual limit does not rise in the future, which is unlikely. That might not seem like a lot, but if you generate a 7% rate of return, that amount will double by the time your child reaches 18. It will continue to grow until the funds are withdrawn from the account, which must occur by age 30.
Of course, any expenses paid out throughout the years will lessen the earning power of the plan. Therefore, funds should only be withdrawn when absolutely necessary. But so long as you have education expenses, you will have the ability to pay for them.
Taking Advantage of the Coverdell ESA
With the rising costs of education expenses, which start at preschool, it’s a smart idea to start saving as soon as possible. The Coverdell ESA allows for a tax-advantaged way to cover some of these expenses. It’s important to note that contributions are irrespective of retirement savings plans. An ESA may be used in conjunction with these plans to save more money with tax benefits.
There are a number of qualified education expenses the plan may be used for. These expenses can be found in detail on IRS Publication 970. Essentially, it covers tuition and fees, books and other supplies, computers and other technological products, tutoring and in some instances, room and board. Lastly, ESA distribution must be less than the total amount of qualified expenses. If you withdraw too much, you will be penalized on the amount over these expenses.
As mentioned earlier, fund must be distributed from the plan once the beneficiary reaches age 30. Another perk of the ESA is that those funds can be transferred a qualified family member of the beneficiary. By rolling over funds, you can avoid the tax consequences that arise. An ESA can be contributed on most closely-related relatives including children, siblings, spouses and first cousins, so long as he or she is under the age of 30.
If you have, or are planning to have, children, it may in your best interest to start funding a Coverdell ESA. While the contribution limits are not substantial, the money will add up if you start early enough. Further, if you invest wisely, funds will grow much faster than in a regular savings account.
You may already have an emergency fund, retirement account or even a Health Savings Account. Adding an ESA to the mix will help when you child starts going to school and the bills, from tuition to books, start adding up. As with any account, it’s important to work with a financial planner to make sure you are doing all you can do to further your child’s education.