Saving for College: Coverdell ESAs

Opening a college savings account is a smart way to invest in the education of a family member, a friend, or even yourself.

There are multiple ways to save for higher education—some with tax benefits—and what works best for you will depends on your (or your loved one's) personal needs and life goals. In this installment of our Saving for College series we'll explore Coverdell Education Savings Accounts.

A Coverdell Education Savings Account (ESA) is a special account designed to help pay for your child's education. You set up the ESA and choose how to invest the money, typically on behalf of the child beneficiary.

When you invest in an ESA, you don't have to pay taxes on investment income or capital gains that accrue inside the account, which means your money has a chance to compound faster. (Contributions aren't tax deductible.)

Even better, withdrawals are free from federal taxes so long as you use the money for qualified education expenses, such as tuition, books, supplies, uniforms, room and board, computer equipment and internet service. If the distribution exceeds the beneficiaries qualified expenses, a portion of the earnings could be taxable to the beneficiary.

Tax-free withdrawals apply not only to college expenses, but also elementary and secondary education expenses—regardless of whether the school is public or private, secular or religious.¹

The table below shows how Coverdell Education Savings Accounts compare to 529 plans.

ESAs offer access to a broader selection of investments than a typical 529, and don't have the 529's $10,000 tax-free withdrawal cap for qualified expenses to an elementary or secondary public, private, or religious school.

Unlike 529 plans, there's an income eligibility limit and a relatively low limit on contributions. The annual maximum is $2,000 per beneficiary—or less for higher earners—which means if you (as a parent) contribute all $2,000, grandparents and other individuals aren't allowed to make additional contributions to the account during that year.

The good news is your child can be the beneficiary of both a 529 plan and an ESA, and you can contribute to both accounts in the same year.

Like with 529 savings plans, if your child decides not to attend college, or there is money left in the ESA account after he or she graduates, the remaining savings can still be used. Unlike with a 529 savings plan, an ESA must be distributed within 30 days after the designated beneficiary reaches age 30, unless he or she is a special needs beneficiary.

You can change the beneficiary on the account to another member of the original beneficiary's family who is under age 30. The IRS broadly defines the term "family member" to include everyone from siblings and parents to stepsiblings and in-laws.

If you withdraw funds for non-qualified expenses, any untaxed earnings are taxable to the beneficiary, along with a 10% federal penalty.

Anyone can set up an ESA at a brokerage or other financial institution, or directly with a mutual fund company. Once an ESA is opened in your child's name, anyone can contribute as long as they follow a few rules:

• No more than $2,000 per year can be put in a child's ESA(s). The beneficiary must be under age 18 during the year of contribution (unless he or she is a special-needs child).
• The $2,000 maximum is dependent on your filing status and modified adjusted gross income (MAGI). Joint filers with a MAGI of less than $190,000 ($95,000 for single filers) can contribute up to the full amount. Contribution limits are lower at higher MAGIs and are completely phased out for joint filers with a MAGI of $220,000 or more ($110,000 for single filers), as shown in the table above.
• The money must be used (or transferred to another beneficiary) within 30 days after the child turns 30.
• You can change the beneficiary to another family member once per year.
• You have until Tax Day of the following year to contribute for the previous year.

ESAs generally receive favorable treatment when it comes to calculating financial aid eligibility, similar to a 529 plan. (With a 529 held in a parent's name, typically up to 5.64% of the assets are considered available for college expenses). However, schools might use slightly different formulas to calculate financial aid eligibility, which could mean ESA accounts listed under a grandparent or non-relative's name might have to be reported.

Saving and investing for college is a wise move, even if you believe your child may qualify for financial aid. Remember, most financial aid comes in the form of loans, which must be repaid with interest.

There are a number of resources for financial aid information, including the U.S. Department of Education and College Board. It's always a good idea to check with your financial planner and a qualified tax advisor to determine which education savings route is best for you and your family.