Coverdell ESA versus 529 plan

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Joseph Hurley

By Joseph Hurley

August 27, 2018

The benefits of the Coverdell education savings account (ESA) were made permanent with the American Taxpayer Relief Act of 2012 (ATRA). Although it was around long before that since 1998–when it was called the Education IRA–the ESA has long been overshadowed by the 529 plan.

Offering investment flexibility that is superior to the 529 plan, potentially lower costs, and tax-free treatment not just for college expenses but for a wide range of elementary and secondary school costs (K-12) as well, the ESA is a worthy competitor for your education-savings dollars.

Actually, the ESA has offered these benefits since the 2001 EGTRRA tax law. (Prior to 2002, the Education IRA was truly an atrocious vehicle, so much so that we at labeled it the ‘Excedrin IRA.’) But over the years we remained reluctant to recommend it, knowing that its improved features were slated to expire at the end of 2012.

If ATRA had not come along to save the ESA, we would be looking at a $500 annual per-child contribution cap beginning in 2013; K-12 expenses would no longer be qualified; and ESA distributions for college would lose tax-free status for any family claiming the Hope/American Opportunity credit or Lifetime Learning credit.



So now we are beyond all that. If your child is young enough–not yet 18 years old–and your income is low enough (the income phase-out is $95,000 to $110,000 for a single taxpayer and $190,000 to $220,000 for a married couple filing jointly), you can contribute up to $2,000 per year to a Coverdell ESA for that child.

Can I use 529 funds to pay for college and still claim the American Opportunity Tax credit?

If your income is too high, first gift the ESA money to your child and have the contribution come from the child.

Just don’t jump in headfirst into a Coverdell ESA without understanding its limitations.

Unlike with 529s, ESA assets are not revocable. The account must be established for the sole benefit of the child, which to me sounds like an UGMA or UTMA account. In fact, an ESA has a custodian–and it’s not you. The ESA custodian is the bank or other financial institution you use to open the account, much like the way you open an IRA.

As the ‘responsible individual’, you get to call the shots on investments and distributions, but distributions from an ESA are always paid to the beneficiary and cannot come back to you. Unspent funds remaining in the account when your child reaches age 30 must be distributed at that time, subject to tax and 10% penalty on the account growth if he or she does not have qualified education expenses in that year.

Federal tax law says the beneficiary can be changed to another family member below age 30 without triggering tax or penalty. But how does that square with the notion that contributions were originally made for one particular child’s benefit? Some ESA agreements provide that only the current beneficiary, after reaching legal age, has the right to change beneficiaries.

Also note, the Coverdell ESA does not work as well as 529 plans for grandparents and other relatives. Let’s say you drop $2,000 into an ESA for your child this year, and a grandparent opens another ESA with $1,000. The annual contribution limit has been breached and your child owes a 6% excise tax on the $1,000 excess.


Most, but not all, ESAs protect against this unfortunate result by requiring that a parent or legal guardian, and not the grandparent, be named as the responsible individual on any ESA set up for your child. So at least you as the parent will get a chance to notice the excess contribution and take it back out of the ESA before May 31 of the following year, thereby avoiding penalties.

But that still does not prevent your little Johnny from facing off with the IRS if a contributing grandparent violates the contributor income requirement, or sends the money in after Johnny turns 18.

Eight reasons why grandparents love 529 plans

If you currently self-direct the investments in your IRA, you may especially appreciate the ability to do the same with your Coverdell ESA. But that does not necessarily mean that your account will perform better than a 529 plan, which offers a limited menu of investment portfolios managed by professionals.


And guess what? Your favorite mutual fund company may not even provide ESAs. Vanguard and T. Rowe Price have stopped taking new ESA applications, and Fidelity Investments has never offered them.

You’ll likely have to keep your own cost basis records with a Coverdell ESA. The IRS has encouraged investment firms to maintain ESA basis records for you, but that remains voluntary. 529 plans are required to maintain your cost basis records, making it easier for you once your begin making distributions.

And be sure to check whether your state offers a state income tax deduction for using a 529 plan. You definitely won’t receive a state income tax deduction for your contributions to an ESA.

Financial aid? The law says that a Coverdell will receive the same treatment as a 529 plan. That’s a good thing, because it moves the ESA out of student assets and into parent assets. Parent assets are assessed more lightly in the federal needs formula.

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If you open an ESA, and you decide later on you would prefer to enroll in a 529 plan, you are permitted to transfer funds to the 529 as long as you keep the beneficiary the same. (An attorney might tell you that the 529 should be designated a ‘custodial 529 account’ to properly transfer the beneficiary’s rights under the ESA.) You cannot go from a 529 plan to an ESA.

Finally, beware of maintenance fees on ESAs as they have greater impact on low-balance accounts. maintains a listing of widely recognized low-cost ESA providers.

We also provide an extensive tutorial on explaining the Coverdell ESA. Be sure to visit.

A good place to start:

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