Top 5 mistakes to avoid when using a Coverdell ESA
A Coverdell Education Savings Accounts (ESA) is a trust or custodial account designed to help families pay for education. Just like a 529 savings plan, a Coverdell ESA offers tax-free earnings growth and tax-free withdrawals when the funds are spent on qualified expenses. Coverdell ESAs aren’t just for college – you can also use your savings to pay for K-12 expenses tax-free, and they can 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.
We surveyed our readers and found that over 84 percent are not familiar with Coverdell ESAs, and less than half know that you can use a Coverdell ESA to pay for private high school or elementary school.
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 to Coverdell ESAs 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 of the 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 and make contributions to a 529 plan at the same time to save for college. Even the smallest amounts deposited on a regular basis will grow over time, and remember, 529 plans don’t have annual contribution limits.
2. Saving too much
Coverdell ESAs are intended for students who are 18 or younger. If you make contributions to your account after the beneficiary turns 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 What’s more, any money left in the account when the student turns 30 must be withdrawn within 30 days.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’re using 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, Coverdell ESAs do have a negative affect on aid eligibility, but the effect is minimal compared to other accounts.
Just like your 529 plan, up to 5.64 percent of the value of a Coverdell ESA owned by a parent or dependent student will be included in the student’s Expected Family Contribution (EFC). If a grandparent or other relative owns the account, nothing will have to be reported until the funds are withdrawn.
Withdrawals taken from parent- or student-owned accounts will be excluded from your federal income tax return, but if a grandparent or someone else owns the account the amount of the withdrawal will be “added back” and counted as student income on the following year’s FAFSA. Student income is assessed at up to 50 percent. That means if a grandparent takes out $10,000 to pay for a grandchild’s college, that grandchild’s EFC will be increased by $5,000. Remember, higher EFC means less financial aid.
4. Not considering income limits
Coverdell ESAs are not for everyone. In fact, if your adjusted gross income is $110,000 or more ($220,000 if filing a joint return), you would not be eligible to use a Coverdell ESA at all. 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 not everyone is 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 make the contribution into their own Coverdell ESA.
5. Not spending withdrawals on qualified education expenses
The tax-free earnings growth and tax-free 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 include:
- Tuition, fees, academic tutoring, special needs services in the case of a special needs beneficiary, books, supplies, and other equipment which are incurred in connection with the enrollment or attendance of the designated beneficiary
- Room and board, uniforms, transportation, and supplementary item and services (including extended day programs) which 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 as well as a 10 percent penalty tax.
A good place to start