Your 2017 Guide to Saving for College With a Coverdell ESA

By Matthew Frankel Markets Fool.com

When it comes to saving for college, Americans have two main options: a 529 Savings Plan or the lesser-known Coverdell ESA. Although Coverdell ESAs aren't well understood by many people, they do have some unique features and benefits, and are a smart choice for college savers who want more investment options than 529 Savings Plans allow.

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What is a Coverdell ESA?

A Coverdell Education Savings Account, or Coverdell ESA, is a tax-advantaged account designed to help families save and invest for the cost of college education.

The Coverdell ESA was formerly known as the Education IRA, and it actually has a very similar structure to the Roth IRA that many people use to save for retirement. As far as the tax structure goes, Coverdell contributions are not tax-deductible, but all qualified withdrawals used for education expenses are 100% tax-free.

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After you contribute your money, you are free to invest it in any stocks, bonds, ETFs, or mutual funds you want -- or you can leave some in cash equivalents like CDs. Your investments can then generate tax-free returns until you withdraw the money.

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Qualified withdrawals for education expenses include tuition and fees, as well as books, supplies, and equipment required for enrollment or attendance. The money can also be used for special needs services, room and board for students enrolled at least half-time, or the purchase of computer equipment.

Eligibility requirements and contribution limits

Coverdell ESAs are designed for low- to moderate-income families, so there are income restrictions that govern whether or not you can contribute to one. Specifically, the ability to contribute to a Coverdell phases out above a modified adjusted gross income (MAGI) of $95,000 for single filers and $190,000 for married couples filing jointly, and taxpayers with MAGI above $110,000 and $220,000, respectively, cannot contribute to a Coverdell ESA at all.

The maximum that can be contributed to a Coverdell ESA is $2,000 per student, per year. Notice that I said per student, not per account. If a child has more than one Coverdell ESA (say, one from you and one from a grandparent), the total contributions to all their accounts each year must be under $2,000. No contributions can be made after the account's beneficiary turns 18, unless they qualify as a special needs beneficiary.

Coverdell ESA vs. 529 Savings Plan

There are some advantages to using a Coverdell ESA to save for your child's education, as opposed to using a 529 Savings Plan, the other main college savings vehicle.

For one thing, the funds in a Coverdell are not limited to just college use, but can be used to cover qualified education expenses at any level. If your child might end up at a private high school, for example, your Coverdell funds can help you pay for it. In contrast, a 529 plan can only be used for higher education.

Another potential advantage is the flexible investment options. When you contribute to a 529 Savings Plan, you generally have the choice of a basket of mutual funds, along with some pre-made age-appropriate investment portfolios, similar to a 401(k). On the other hand, your Coverdell can be used to invest in virtually any stock, bond, or fund that trades on the major exchanges.

The major downside to a Coverdell ESA is the relatively low contribution limit. 529 Savings Plan contributions vary by state, but in many cases, you can put as much as you want into the account until it reaches $300,000 or more. The Coverdell's limit of $2,000 per year, per student, translates to a total of $36,000 invested if you start when your child is born and max out the account every year until he or she turns 18.

Of course, there's no reason you can't use both account types, and many people do just that in order to take advantage of the benefits of both.

How much could you save in a Coverdell ESA?

The amount of money you can accumulate in a Coverdell ESA depends on how much you save each year, and how well your investments perform. There's no way to know exactly how well your investments will do over time, but an annual average of 7% returns is a reasonable amount to expect, with a properly diversified portfolio.

Here's a quick calculator that can help you estimate the compounding power of a Coverdell ESA and how much the tax savings could be worth to you.

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

What if my child doesn't go to college or need the money?

This is probably the most common question I get from friends and family regarding college savings. What happens to the money in the account if your child doesn't go to college or need the money to pay for it? There's a rule that says the funds in a Coverdell ESA need to be used by the time the beneficiary turns 30.

Sure, you can simply withdraw the cash, but you'll get hit with a penalty for doing so. Therefore, this is rarely a good idea.

The best option is to roll the money over to another qualified beneficiary who is a member of the account beneficiary's family under the age of 30. This can include a sibling, niece/nephew, cousin, or a spouse of any of these individuals.

The bottom line is that a Coverdell ESA can be a smart way to save money for your child's (or another relative's) education, and there are good options available if the beneficiary doesn't end up needing the money.

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