Consider using Coverdell accounts to save for a child’s education.
This episode is about a great way to save for a child’s education using Coverdell Education Savings Accounts (ESAs).
What’s a Coverdell ESA?
In last week’s show I discussed the advantages of using 529 plans to save for higher education. Today’s topic is about another tax-advantaged account that can be used to save for any level of education, from kindergarten through graduate school. It’s called a Coverdell savings account. Coverdells also differ from 529 plans because they’re not as flexible. They place limitations on who can contribute, how much can be contributed each year, and the age of the student who’ll use the funds.
Who Can Have a Coverdell
When you open a Coverdell, the account must be for a designated beneficiary who’s under the age of 18. After the student’s 18th birthday, no more contributions can be made unless the account is for a special-needs beneficiary. The funds must generally be used by the time the student reaches age 30 in order to avoid taxes and penalties.
Qualified Coverdell Expenses
With Coverdells and 529 plans, your contributions and earnings always grow tax-free as long as distributions are used to pay for qualified expenses at eligible schools. Coverdell funds can be used to pay for the student’s tuition and all associated fees, books, equipment, and supplies for their attendance at an eligible institution. This could be any postsecondary school such as a university or college that’s eligible to participate in federal student aid. Coverdell funds can also be used for reasonable room and board for those who are considered at least half-time students.
The unique feature of Coverdells, is that they can also be used to pay for the expenses of younger students. This includes children in kindergarten through grade 12 who attend any eligible public, private, or religious school. There are more qualified expenses for younger students than for those getting post-secondary education. These include tuition, fees, books, supplies, computer equipment, Internet access, academic tutoring, uniforms, transportation, and room and board. Any school you’re interested in can tell you if they’re eligible to accept Coverdell funds.
You can contribute to a Coverdell savings account only if your adjusted gross income is less than $110,000 or less than $220,000 if you file a joint tax return. Companies and trusts are even allowed to make contributions to Coverdells, no matter how much income they earn.
There’s an annual contribution limit of $2,000 per student. This limit applies even if more than one Coverdell account has been opened or more than one person makes contributions for the same beneficiary. Consider this scenario: after a lucky child is born, her parents decide to set up a Coverdell for her and her grandparents also decide to set one up. This is fine as long as the total contributions for the child to all her Coverdell accounts don’t exceed $2,000 per year. If the parents were to contribute $500 and the grandparents $1500, together they have maxed out the allowable yearly limit for the child.
If you want to save more than $2,000 a year for a child’s education, you can also open and contribute to a 529 plan for them in the same year. The deadline for making Coverdell contributions is the due date for filing your tax return for the prior year. So if you want to contribute to a Coverdell for the 2008 tax year, you have until April 15th of 2009 to do it.
Here’s a tip if you earn too much to contribute to a Coverdell: simply gift the money to the student, and help them open up the account for themselves. This assumes you don’t have the next Bill Gates on your hands already earning over the allowable limit before his or her 18th birthday!
What if you can’t use all the Coverdell funds for the beneficiary’s qualified expenses? Maybe the student graduates with all her education bills paid, but there’s still $1,000 left in the account. If the left over money is withdrawn, this will generally be considered a taxable distribution, also subject to an additional 10% tax penalty.
Here’s a tip for dealing with excess Coverdell funds: instead of closing the account and taking a taxable distribution, change the designated beneficiary to a member of the student’s family who’s a potential student. This can include siblings, step-relatives, and cousins of the student, for example. See IRS Publication 970 for complete details on Coverdell accounts and a list of qualified family members for making a beneficiary change.
How to Open a Coverdell
Coverdells can be opened with traditional or online brokerages as well as with many banks and mutual fund companies. I’ll include a link in the show notes at moneygirl.quickanddirtytips.com to some low cost-Coverdell providers.
Coverdells are great if you’re saving for a younger child’s elementary or high school education. But when you’re saving only for college expenses, consider the advantages of the 529 plan. As I discussed in last week’s show, 529 plans have no limit for annual contributions and offer more flexibility than Coverdells when saving for higher education.
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