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Intro to ESAs
(Coverdell Education Savings Accounts)
Advantages and disadvantages
- Whatís so great about the ESA?
- So how does it work?
- I donít expect my child to be in a particularly high tax bracket during college or in the years leading up to college. Does that mean I lose the tax-advantage?
- I'm not sure I understand that part. How can I be sure that I am getting the most tax benefit?
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 account. There are some items to be aware of, however, such as the following:
- There are certain eligibility requirements in the year you wish to contribute to the ESA, which means that not everyone will find them useful. For example, tax law prohibits ESA funding once the beneficiary reaches age 18.
- 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.
- 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.
- 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.
- The ESA 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. Withdrawals are not reported as student or parent income as long as it is tax-free for federal income taxes.
- Coordinating withdrawals with other tax benefits, especially the Hope or Lifetime Learning credits, can be tricky.
- The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties.
If you know how a Roth IRA works, then you have a pretty good idea of how an ESAs works. They both allow you to make an annual non-deductible contribution to a specially designated investment trust account. Your account will grow free of federal income taxes, and if all goes well, withdrawals from the account will be completely tax-free as well. You will need to meet certain requirements in the years you wish to make the contributions, and in the years you take withdrawals. (More on these requirements later.)
But a ESA is an investment vehicle targeted to education expenses, not to retirement.
I donít expect my child to be in a particularly high tax bracket during college or in the years leading up to college. Does that mean I lose the tax-advantage?
Well, yes, at least to some extent. But even if your child is in the 15% tax bracket, thereís some tax savings to be had. And if you live in a state that imposes an income tax, you may save even more (just about every state follows federal tax treatment of the ESAs).
Some families will find that some portion of an ESA withdrawal will be taxable, even when used for college. That's because they may be claiming an American Opportunity tax credit or Lifetime Learning credit, or taking the above-the-line deduction for tuition payments. The tax law will not allow you to "double-dip" by claiming multiple tax breaks for the same expense.
The tax law says that beginning in 2002 your pool of "qualified expenses" for taking tax-free ESA withdrawals is reduced by the tuition you use to claim the Hope, American Opportunity or Lifetime Learning credit. This means that some portion of the ESA withdrawal can become taxable. The good news is that you get to choose the approach that provides you the most benefit. The bad news is that your taxes are complicated by the need to figure out which way is best. Tax-free Coverdell withdrawals also reduce the amount that you might otherwise be able to claim as an above-the-line deduction for college tuition payments under a provision effective for years 2002 through 2013.