If you have children, or if you’ve ever been a student, you know that saving for college is akin to teaching children to brush their teeth—it’s an investment in their long-term well-being. Given the rising costs of college and the debt load many graduates (and their parents) may carry, it may be important to start saving before they start teething.
Sure, regular deposits into a savings account can be a fine way to get going, but many investment professionals suggest looking into tax-free investment accounts such as Coverdell Education Savings Accounts (ESA) as a way to help augment those savings.
ESAs were once referred to as Education IRAs and were a popular choice among those saving for college, before 529 College Savings Plans came about in 1996. They have some investing advantages over 529 plans, but the 2017 tax reform legislation might have helped further curb Coverdell ESAs. For the first time at the federal level, 529 plans can be used to help cover qualified school expenses at private elementary and high schools as well as college, making them a competitor to Coverdell ESAs. This new ability to use 529 Plan funds for qualified K-12 expenses is also dependent on each state, so it’s important to check with your plan and a qualified tax advisor before using 529 funds for K-12 expenses.
Coverdell vs. 529 Plan
A Coverdell ESA is a trust or custodial investment vehicle that allows you to contribute money for a designated beneficiary—who must be named when the account is established—tax free, and withdraw it tax free when the funds are used to pay for qualified education expenses. Contributions to a Coverdell can be invested in a variety of assets like stocks, bonds, and mutual funds. The contributions themselves are not tax deductible.
Education expenses covered in both Coverdell ESAs and 529 plans are relatively the same under IRS rules. The funds can be used for any eligible education: private, public, or religious kindergarten, elementary, or high school, as well as higher education.
Qualifying expenses for Coverdell ESAs include tuition and fees, of course, plus books, supplies, and equipment such as computers and tablets, software, Internet connections, and even academic tutoring. They can also be used to cover the costs of room and board, uniforms, transportation, and supplementary items like extended after-school programs.
Non-qualifying expenses include computer software for sports, games, and hobbies, “unless the software is predominantly educational in nature.” If the distribution exceeds the beneficiary’s qualified education expenses, a portion of the earnings is taxable—to the beneficiary, according to the IRS.
As of March 2018, the annual contribution to each designated beneficiary (namely, “student”) is capped at $2,000. Each student can have more than one Coverdell ESA, but the total amount deposited in all of them must not exceed $2,000 in each calendar year. You can only establish a Coverdell if your modified adjusted gross income is under $110,000 ($220,000 if filing jointly), according to the IRS. Under current rules, contributions are allowed to be made for individuals under the age of 18 or for older special-needs beneficiaries.
Coverdell as an Alternative or an Add-On to Other Plans
You don’t necessarily have to choose between a Coverdell ESA versus a 529 plan, Roth IRA for education, or other savings plan; you can mix and match. Yes, you can invest for the kids’ education in all accounts simultaneously.
Like most investment vehicles, there are pros and cons, and the pros of Coverdells—tax-free withdrawals, breadth of qualified expenses, and flexible investment options—must be weighed against the drawbacks, such as the age limit of 18 and the annual contribution limit of $2,000. However, beneficiaries can withdraw the money for education-related expenses until they are 30 years old without incurring federal taxes and a 10% penalty.
The income level is a sliding one. For both the 2017 and 2018 tax years, contribution eligibility phases from $190,000 to $220,000 for couples, and from $95,000 to $110,000 for single filers.
TD Ameritrade does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.
All investing involves risks, including loss of principal.