A couple of posts back we introduced college savings options. Last time we covered the 529 plans. Today’s blog is on the other tax-favored option, the Coverdell account or Educational Savings Account (ESA). This plan could just as easily have been called the 530 plan because it is governed by section 530 of the IRS tax code. However, it was championed by the late Georgia senator Paul Coverdell, so Coverdell has stuck as an appropriate nickname. Much like the 529 plan, it allows proceeds to grow tax-deferred and be withdrawn tax-free to be used at a qualified institution. However, the differences are much more profound than the similarities. Let’s explore them below.
An ESA has an annual limit on contributions. Up to $2,000 per year per child can be contributed to an ESA, and that contribution is not tax-deductible. Your ability to contribute to an ESA is affected by your income; as of 2011, a married couple filing jointly loses their ability to contribute when their adjusted gross income exceeds $220,000, and $110,000 for single taxpayers. A separate account must be maintained per child, and the proceeds in an account must be used by the time the beneficiary is 30 years old. It may be transferred to another family member under the age of 30 if the beneficiary does not need the funds for educational purposes. Although the proceeds must be used by age 30, no contributions may be made on behalf of a beneficiary after they reach the age of 18.
Your investment options with an ESA are much broader than with the 529 plan. You may create an educational savings account with any bank or brokerage house that is approved to offer Coverdell accounts and invest your contributions in a wide range of choices. You may choose cash or cash equivalent accounts, or opt for higher returns from mutual funds or other investment options available through the account. Shop the various Coverdell account providers as you’ll find a vast array of products, and associated fees, tied to these accounts. Remember that higher fees don’t always equate to higher returns, so if in doubt use a local fee-only financial advisor to assist you with selecting the best-fit product.
Finally, one of the best features of the ESA is the ability to use these funds to pay for fees associated with primary and secondary education. This means if you want to send your child to a private elementary, middle, or high school then the funds in an ESA may also be used to pay for qualified expenses at these schools. In whatever means the ESA is used, it must be for qualified educational expenses, and the amount withdrawn each year may not exceed the amount of qualified expenses minus any other tax-free educational assistance received. If you withdraw more than this amount, then any excess is subject to taxes on the earnings portion plus a penalty of 10%.
You may choose to contribute to both an ESA and to a 529 account. If you do, just be aware of the income limits on ESA contributions and contribution limits on both types of accounts. These two accounts can work together along with all other tax-free educational assistance and tax deductions and credits to get the best use of your college savings dollars. As of this writing, IRS Publication 970 provides all of the tax provisions for both accounts and lists the available deductions and credits that you are able to take as a college student. Be sure to understand the provisions of this publication or work with your tax professional to ensure the proper use of these accounts.
Next time we’ll wrap up this discussion by discussing regular savings options and provide you with a helpful guide to decide which savings options best suit your personal situation.