An education savings account (ESA) is one way to put money aside for educational expenses. With the average college tuition costing anywhere from $5,500 to $24,000 per year, you may want to start looking for ways to save for your kid’s college earlier than later.
What Is a Coverdell Education Savings Account (ESA)?
Created in 2002, the Coverdell ESA is an updated version of the Education IRA. It is a tax-deferred trust account created by the federal government to assist families in funding educational expenses. The account beneficiaries must be younger than 18 years of age when the account is established. Part of the Coverdell changes allows families to use the funds in an ESA for elementary and secondary school expenses and college education. Up to $2,000 per child can be placed in a Coverdell account in a tax year.
Before deciding if a Coverdell ESA is suitable for your family, consider the following stipulations:
- Contributions are not allowed after the beneficiary of the account reaches age 18.
- Each child is limited to a total ESA contribution of $2,000 per year. If a child has multiple accounts, the maximum amount deposited in all accounts cannot exceed more than $2,000 without incurring penalties.
- Financial institutions can assess fees on an ESA.
- ESA funds are distributed to the child once they reach age 18, even if they do not attend college. The funds cannot be returned to the account custodian.
- ESA accounts like 529 plans are considered the account custodian’s (parent) asset when calculating federal financial aid.
- The beneficiary must withdraw all funds by age 30; otherwise, the money will be subject to taxation and penalties.
The ESA has advantages over other saving instruments; however, the beneficiary (child) has control of the funds once they reach age 18. That means the money does not have to be used for educational purposes.
How Does a Coverdell Education Savings Account (ESA) Work?
Parents or other adults make nondeductible contributions to a child’s ESA up to the maximum limit per year. The money grows tax-free and qualified withdrawals are also tax-free. As with most government-created accounts, there are eligibility requirements. ESA beneficiaries must be under the age of 18 when the account is established and may not receive contributions once they reach age 18. However, the beneficiary does not have to be related to you.
Your income determines how much you can contribute to an ESA. To contribute the maximum, you must have a modified adjusted gross income of less than $190,000 for couples or $95,000 for individuals. There are phased contributions if your income falls between $190,000 and $220,000.
Any financial institution or investment firm that serves as a custodian or a traditional IRA can offer a custodial ESA account. Contributions can be invested in any qualifying instrument such as stocks, bonds, or mutual funds offered by the sponsoring institution. As with a traditional IRA, you open an account with an authorized institution, select the type of investment, and make contributions.
Education Savings Account vs. 529 Plan
Both an ESA and 529 are investment accounts funded with post-tax dollars. Withdrawals are usually tax-free, as is any growth in deposited funds. When comparing the two options, consider the following:
- Beneficiary Transfer. Both accounts let the child transfer funds to a sibling.
- Withdrawal Penalties. A 10% penalty applies to unqualified withdrawals, which also become taxable.
- Investment Options. 529 plans have restricted investment options as compared to ESAs.
- Contribution Limits. ESAs have a $2,000 limit, but 529s do not have a limit as long as the amount is below the gift tax threshold of $15,000.
- Qualified Expenses. ESA and 529 plans are designated for educational expenses for children in grades K-12 or college.
- Age Restrictions. Most 529s do not have age restrictions. ESAs may be opened for any child under 18, but contributions cannot be made after the child reaches age 18.
- Income Restrictions. If your income exceeds $220,000 for couples or $110,000 for individuals, you cannot contribute to an ESA. No restrictions apply to 529.
An ESA has more investment flexibility but limits contributions; 529s allow for higher contributions and investment restrictions. What works best for you and your family depends on your income and educational needs.
