A Coverdell Account Can Help You Invest for Your Child's Education

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A Coverdell Education Savings Account, also known as a Coverdell ESA, is a tax-advantaged savings account designed to help with education expenses. While they have lower contribution limits than other education savings plans and have clearly defined withdrawal rules, Coverdell accounts can be used for all levels of education, not just college.

What is a Coverdell?

A Coverdell Education Savings Account, or Coverdell ESA for short, is a tax-advantaged account designed to help save for educational expenses.

The tax structure of a Coverdell ESA is the same as a Roth IRA. Contributions are not tax deductible, but savings and investments can grow and compound tax-free, and any qualified withdrawals will have no tax liability.

Coverdell ESA contributions are limited to $2,000 per year, per beneficiary. One beneficiary can have multiple Coverdell accounts, but the total annual contributions cannot exceed this limit. Once money is contributed to a Coverdell ESA, it can be invested in virtually any stocks, bonds, or mutual funds you'd like, or it can be left in cash or money market assets.

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Account funds can be used for qualified educational expenses, such as tuition and fees required for enrollment, room and board, books and supplies, and computers. And unlike the other major college savings account (529 savings plan), Coverdell funds are not limited to college expenses -- rather, they can be used for any educational level (such as a private high school). If the beneficiary is in elementary or secondary school, tutoring services, school uniforms, and transportation expenses can also qualify.

Finally, it's important to know the options if the account beneficiary doesn't end up needing all of the funds or doesn't end up needing them at all. In this case, there are two options. The beneficiary can withdraw the money and pay taxes on investment profits, although this is rarely a financially sound idea. Or he or she can transfer the account to another beneficiary, such as another child, a niece or nephew, or another relative under age 30. There is no cost to do this, and it's a rather painless procedure.

Advantages and disadvantages

There are several advantages of investing for education expenses through a Coverdell ESA. Just to name some of the main perks:

  • Coverdell ESA investments grow on a tax-deferred basis, and qualified withdrawals are tax-free.
  • You can use Coverdell ESA funds for any educational level, not just college.
  • Coverdell ESA contributions can be invested in a wide variety of stocks, bonds, and funds. In contrast, 529 savings plan investments are generally limited to a small assortment of mutual funds, like most 401(k) plans.

However, there are some key drawbacks to be aware of:

  • Coverdell ESA contributions are limited to $2,000 per year, per beneficiary. In contrast, many 529 savings plans don't limit contributions until the account's balance reaches $400,000 or more.
  • The ability to open a Coverdell ESA is income-restricted. Specifically, your modified adjusted gross income (MAGI) must be $95,000 or less if you're single, or $190,000 or less if you file a joint tax return to make a full Coverdell ESA contribution. The ability to contribute disappears completely above MAGI of $110,000 and $220,000, for single and joint tax filers, respectively.
  • Distributions in excess of qualified educational expenses may be taxable.
  • You can no longer contribute to a Coverdell ESA once the beneficiary turns 18.
  • You have less control over Coverdell ESA contributions than you do with 529 plans. Coverdell contributions will eventually be distributed to the beneficiary, even if not used for school. In contrast, 529 savings plan contributions can be refunded back to the contributor if requested.

How to invest in a Coverdell ESA

The best way to approach college savings is the same way you should approach retirement saving. Start out investing aggressively and gradually get more conservative over time.

For example, in an account for a two-year-old, you should have the bulk of your assets invested in high-quality stocks or stock-based mutual funds. Or, for a 17-year-old high school senior, the majority of the account should be in fixed-income or cash-equivalent assets, since there isn't time to recoup any possible losses. It depends on how soon you plan to use the money and your personal appetite for risk.

Is it right for you?

A Coverdell ESA can be a great option for many people, but it's important to be aware of the drawbacks. It's certainly nice to have the flexibility to invest in what you want and to use the money for elementary and secondary expenses, as well as for college. However, the $2,000 annual contribution limits may not even cover the cost of in-state tuition, even if your investments perform well.

As a final note, it's important to mention that you can have both a Coverdell ESA and a 529 savings plan. If you plan on saving more than a Coverdell allows, one potential strategy would be to invest the first $2,000 each year in a Coverdell and the excess in a 529, to take full advantage of both options.

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