Although Coverdell Education Savings Accounts are a much less popular alternative than 529 plans when it comes to saving for college, these accounts do offer some advantages over their more prestigious cousins. They have come a long way since their inception as educational IRAs in the 1990s, and they provide a viable alternative for school savers with greater freedom of choice than 529 plans.

Here’s what advisors and their clients need to know about these accounts and how they can be used to pay for scholastic expenses. (For further reading, see: Don't Forget the Kids: Save for Their Education and Retirement.)

Coverdell Rules

Donors can place up to $2,000 per year per beneficiary into a Coverdell ESA. Although contributions to Coverdell ESAs are not deductible, the money that is placed inside them does grow tax-deferred until it is withdrawn to pay for school expenses. The designated beneficiaries of these accounts must be below the age of 18 or have special needs, and must also be at least a half-time student in order for distributions to be tax-free.

All money that is withdrawn from Coverdell accounts must be used for qualified educational expenses, which includes tuition, fees, tutoring, uniforms, transportation, books and other equipment that is required for schooling and room and board. The purchase of computers and internet access can also qualify as an education expense if these things are necessary for school.

Money can remain in these accounts until 30 days after the designated beneficiary turns 30 years old. At that point, any unused money in the account becomes taxable and will be assessed a 10% penalty. There is also an income limit phaseout schedule for those who make contributions to Coverdell ESAs. Single filers with modified adjusted gross incomes above $95,000 and joint filers with MAGIs above $190,000 cannot make the full $2,000 contribution, and those with MAGIs above $110,000 and $220,000 respectively cannot make any contributions to these accounts. However, donors with incomes that are too high to permit contributions can give money to the beneficiary or another person whose income falls below the threshold, and they can then make the contribution. (For related reading, see: ESAs: Avoiding Taxes on Distributions.)

Although Coverdell ESAs have a very low contribution limit compared to 529 plans, families who can only afford to contribute $2,000 or less to these accounts may find them more attractive than 529 plans because they are self-directed and can be invested in just about anything except for life insurance. But they can hold stocks, bonds, mutual funds, REITs, UITs, ETFs or just about anything else that’s publicly traded. 529 Plan users only get to choose from the fund options that are available in their state’s plan. And unlike 529 Plans, Coverdell ESAs can also be used to pay for primary or secondary schooling. This can be a big help for parents who are sending their kids to private schools and would like to start saving for this expense.

Coverdell ESAs are available at banks, brokerage and investment firms and directly through mutual fund companies.

One other drawback that Coverdell ESAs have compared to 529 Plans is that there is no state tax deduction available for their contributions. While many states offer tax deductions for 529 plans, this does not exist for Coverdell contributions. (For more, see: Can I Contribute to Both a 529 Plan and a Coverdell ESA?)

The Bottom Line

Coverdell ESAs still trail 529 plans in popularity by a wide margin due to their relatively low contribution limits. However, these accounts can be a viable alternative for lower-income families who cannot afford to make substantial contributions. They can also be used to pay for expenses for grades K-12, which can help to defray the costs of private school or tutoring. For more information on Coverdell ESAs, consult Publication 970 on the IRS website. (For related reading, see: Best Savings Priority: Retirement vs. College Fund.)

 

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