When looking at different ways to pay for college, students and parents should consider a variety of options that make sense for their financial situation.
For parents who are looking to create a savings account that can be used for a wide range of education expenses, a Coverdell Education Savings Account may be a good fit.
Formerly known as the Education IRA, Coverdell ESAs allow account users to diversify their investment portfolio to create a savings vehicle for a beneficiary under the age of 18.
“There is no limit to the number of accounts that can be established for a beneficiary, but the sum total of the amount contributed in these accounts is limited to $2,000 per year, per beneficiary,” says PK Palvia, certified public accountant and managing director of Tax & Accounting Advisors. “If your father has contributed $1,200, then your grandfather is limited to just $800 for that year.”
Anyone can contribute to a beneficiary’s Coverdell ESA as long as the contributing individual’s modified adjusted gross income is less than $110,000 a year if single and $220,000 if filing a joint return, according to the IRS.
The money in this account grows tax-free as long as it is used for qualified educational purposes, which includes room and board, tuition, fees, books, supplies, tutoring, and special needs services, according to Palvia.
Any assets left in a Coverdell account within the 30 days after the beneficiary turns 30 years old or if the beneficiary dies before their 30th birthday must be distributed or it will be taxed, with an additional 10% tax penalty on the amount.
To avoid this, Palvia suggests that the remaining funds can be rolled over into another Coverdell ESA for the same beneficiary or a member in their family who is under age 30.
Advantages of Coverdell ESAs
Unlike custodial accounts that count as the student’s assets and can affect their ability to get federal financial aid, Coverdell ESAs have minimal impact on a student’s aid eligibility as long as the account is in the parent’s name, says Mark Kantrowitz, publisher of FinAid.org and FastWeb.com.
“It’s seen as a 529 college savings plan or prepaid tuition plan, so it’s a favorable treatment,” he says.
David Zuckerman, principal and chief investment officer at Zuckerman Capital Management LLC, explains that a big advantage for Coverdells is the flexibility of investment choices.
“The tax treatments are more or less identical to a 529 plan,” he says. “The difference is with a Coverdell, you’re able to buy any stocks, bonds, mutual funds and other securities that you can buy in an IRA account, so you do have a much greater variety of investments to select from than say in a 529 plan.”
Katrowitz points out that Coverdell ESAs can make sense for children with special needs due to the flexibility in being able to use the money even after the beneficiary turns 30 years old.
“For most people, it’s fine because if you go to college straight out of high school at 17 or 18 years old and let’s say that it takes you four years, so you’re 21 or 22 and you go on to graduate school for another four years, 26 is well below that 30 year threshold,” he says. “Even if someone takes a break between going to college, the age 30 threshold will not be much of an impediment.”
Unlike state sponsored 529 plans, which can only be used for higher education, federally- sponsored Coverdell ESAs can currently be used to pay for elementary and secondary school education costs.
“I think the best candidate for a Coverdell savings account would be an upper middle class family that’s below the income phase out levels that have kids that are going to private school for high school and junior high and possibly earlier than that,” says Zuckerman.
Disadvantages of Coverdell ESAs
Although putting away any amount of money for school can help in the long run, the Coverdell ESA restricts investors from contributing more than annual limit—the penalty for excess contributions is a 6% excise tax. Because of the small contribution limit, an annual fee to maintain the account could make an impact on your savings and your overall investment return, says Zuckerman.
With the cost of tuition rising faster than inflation, the capped contribution amount could affect how much of your child’s total education expenses will be covered.
“Because your contributions are limited, you’re not going to be able to accumulate very much money,” says Kantrowitz. “$2,000 a year for 17 years is not going to make a very big dent in a private college—it might be enough for a public college.”
Coverdell ESAs previously had a contribution limit of $500, which was temporarily increased to $2000 for a two year extension. When the extension expires next year, it is still unclear whether or not Congress will drop back down to the lower contribution limit due to budget deficit issues. In addition, Congress may decide that elementary and secondary education expenses will no longer be covered under Coverdells.
“There’s a good chance that all of the extensions and tax benefits that there were may be much more limited in the future,” says Kantrowitz.
For the increasing amount of nontraditional students (older students returning to school who may have families and jobs), a Coverdell ESA may not make sense due to the 30 year old age threshold, unlike 529 plans which don’t have any age restrictions, says Kantrowitz.
“Overall, my view is that the 529 college savings plans are a much better type of plan for most families because not only do you have all of the tax advantages, but you also have the state income tax deductions for your contributions in 34 states and the District of Columbia,” says Kantrowitz.