Have you ever wondered about the best ways to plan for your child’s education? Interestingly, our recent survey revealed that over 84 percent of our readers are not familiar with Coverdell ESAs, and less than half know that they can use a Coverdell ESA to pay for private high school or elementary school.
So, what is a Coverdell Education Savings Account (ESA)? And what does it have to offer? A Coverdell account is a tax-advantaged trust or custodial account designed to help families pay for education costs. Like a 529 savings plan, a Coverdell ESA offers tax-free earnings growth. In addition, distributions from a Coverdell account are tax-free as long as they are used for qualified education expenses.
Sometimes referred to as Education IRA, Coverdell ESAs aren’t just college savings plans: You can also use your savings to pay for K-12 expenses tax-free. They can also offer more investment options and lower fees than 529 plans. Their tax benefits were set to expire but became permanent with the American Taxpayer Relief Act of 2012. In addition, any family member or the beneficiary can contribute to a Coverdell ESA account if the contributor’s MAGI is within the eligible range. If you want to start saving for elementary school, high school, or college, a Coverdell is one of your best options. You can see a list of providers here. But before you decide to open an account, be sure to look out for these five common pitfalls.
1. Not saving enough
Over half (59.2%) of our survey respondents weren’t sure if 529 plans or Coverdell ESAs have annual contribution limits. While there is no limit to the amount you can deposit into a 529 plan each year, annual contributions for tax year 2023 cannot exceed $2,000 per student per calendar year. This applies even when a student has more than one account – you can still only deposit a total of $2,000 across all accounts. And as you know, that won’t put much of a dent in an elementary, secondary, or college tuition bill. In fact, according to the Private School Review, the average private elementary school tuition was $9,200 per student in 2017-18.
But every little bit does help. And if your annual tuition is $10,000, that means you’ll be able to cover 20 percent tax-free with a Coverdell ESA. Just be sure not to stop there. If you’re putting money away for elementary or high school, try to make contributions to a 529 plan at the same time to save for college. Even the smallest amounts deposited regularly will grow tax-deferred over time, and remember, 529 plans don’t have annual contribution limits.
2. Saving too much
While it’s essential to save as much as possible, there is such a thing as saving too much in your Coverdell ESA. The IRS imposes penalties on excess contributions. Specifically, if you contribute to your ESA account after the beneficiary reaches 18, these deposits will be subject to a 6 percent excise tax. What’s more, any money left in the account when the student turns 30 must be withdrawn within 30 days. If not, the earnings portion will be subject to income tax and a 10 percent penalty tax.
3. Not understanding the effect your savings will have on financial aid eligibility
This is especially important if you use your Coverdell ESA to pay for college. When we asked our readers which types of college savings vehicles negatively affect financial aid eligibility, over half (56.7%) of the respondents said they didn’t know, and only 11.6 percent said Coverdell ESAs. The truth is that Coverdell ESAs do decrease aid eligibility, but the effect is minimal compared to other accounts.
Like your 529 plan, up to 5.64% of the value of a Coverdell ESA owned by a parent or dependent student will be included in the Student Aid Index (SAI), formerly Expected Family Contribution (EFC). If a grandparent or other relative owns the account, nothing will have to be reported.
Withdrawals taken from 529 plans – whether owned by a parent, student, grandparent or someone else – will not be counted as student income on the following year’s FAFSA.
4. Not considering income limits
Coverdell ESAs are not for everyone. If your modified adjusted gross income (MAGI) is $110,000 or more ($220,000 if filing a joint return), you would not be eligible to use a Coverdell ESA. Your ability to contribute up to $2,000 for any child is reduced on a ratable basis as modified AGI rises above $95,000. Our survey once again showed that only some are aware of these limits. When asked what is the best savings tool for a couple making $225,000 per year, over 11 percent said a Coverdell ESA.
If your income is too high to make Coverdell ESA contributions, consider gifting the money to someone who does qualify (even the child) and have that person contribute to their own Coverdell ESA.
5. Not spending withdrawals on qualified education expenses
The tax-free earnings growth and withdrawals offered by a Coverdell ESA only apply when the funds are used to pay for qualified elementary and secondary education expenses (QESEE) or qualified higher education expenses (QHEE). Remember, if you’re using a 529 plan to pay for elementary or high school, your qualified expenses are limited to tuition costs, but QESEE for a Coverdell ESA includes:
- Tuition, fees, academic tutoring, special needs services in the case of a special needs beneficiary, books, supplies, and other equipment that are incurred in connection with the enrollment or attendance of the designated beneficiary
- Room and board, uniforms, transportation, and supplementary items and services (including extended day programs) that are required or provided by the school in connection with such enrollment or attendance
- Any computer technology or equipment or Internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in school.
The earnings portion of all non-qualified withdrawals will be subject to income tax and a 10 percent penalty tax.