How to Use a Coverdell Account for Children's Education

Among the various tax-favored college payment plans is the Coverdell Education Savings Account, previously known as an education IRA. And Coverdell accounts are earning a better grade from taxpayers who are looking to stash cash for Junior's schooling.

Up to $2,000 can be contributed annually to a Coverdell account. Plus, you have more contribution timing flexibility; you can pay for more types of education expenses with the money, and you can combine Coverdell cash with other education tax breaks. If the plan is owned by a parent, it's considered a parental asset and therefore has a minimal effect on the amount of financial aid available.

While adults contribute to the savings plan, a child age 17 or younger (unless a special needs child) is named as the account's beneficiary. The contributions aren't tax deductible, but they do grow tax-free, and the funds can be withdrawn tax-free as long as they are used to pay eligible schooling costs.

Expanded better benefits

Coverdells were made a permanent part of the tax code under the American Taxpayer Relief Act enacted in January 2013. The savings plan, renamed in honor of the late U.S. Sen. Paul Coverdell of Georgia, offers several benefits.

In addition to the $2,000 contribution limit, the Internal Revenue Service now allows:

  • Money to be added to the plan up until the tax-filing deadline of April 15.
  • Contributions for a child 18 or older if the youngster has special needs.
  • Any adult -- parents, grandparents, godparents or friends -- to put money in a child's education IRA, but the total put in the account from all sources cannot exceed $2,000. There's a 6% annual excess contribution tax if more than that is contributed for the same child, even when the money comes from different people.
  • Higher income limits for contributors. To contribute fully, a person must make no more than $95,000 if filing as single taxpayer and $190,000 if married filing jointly. Limited contributions are allowed for single taxpayers earning up to $110,000 and married couples making up to $220,000. Beyond those higher incomes, a person cannot contribute. And remember, the contributions are simply for the future education of the child. The contributor gets no tax break for adding to the account.
  • Money to be used for some pre-college expenses, including tuition, room and board, books and computers for public, private or parochial elementary and secondary schools.
  • Money to be simultaneously contributed for the same child to a Coverdell account and a state college tuition program.
  • A distribution from the account in the same year that the American Opportunity or Lifetime Learning credits are claimed as long as the money is not used to pay for the same expenses.

Selecting an account home

OK, you've determined that a Coverdell Education Savings Account is a worthwhile component of your child's overall educational savings plan. So where do you put the money?

Any financial institution (a bank, investment company, brokerage, etc.) that handles traditional IRAs can help you set up and manage a Coverdell account. You can put your contributions into any qualifying investment vehicle -- stocks, bonds, mutual funds, certificates of deposit -- offered at the institution that will serve as the account's custodian.

If you want to diversify, you can split the money up into several investments. There's no limit on the number of Coverdell accounts that you can establish for a child. The only limit is on the total contributions: You can't put more than $2,000 a year away for the student, regardless of how many accounts he or she has. Just be sure that management fees for multiple accounts don't eat into your overall savings return.

Unused Coverdell money

If Junior decides college is not really for him, what happens to any unused education IRA money diligently contributed all these years? Then the student pays at age 30, withdrawing any balance in the account within 30 days of the 30th birthday, and owing tax on the earnings plus a 10% penalty.

The IRS, however, offers a way out of this taxable situation. The student can roll over the full balance to another Coverdell plan for another family member. This could be a younger sibling, niece, nephew, son or daughter.

Copyright 2014, Bankrate Inc.