The Coverdell Education Savings Account (ESA) is an ideal option for parents and grandparents who wish to start early in supporting the education of their loved ones in college. Like any other investment, it is important to understand the fine details of this long-term savings tool, and this beginner guide is an excellent place to start.
What is a Coverdell Education Savings Account?
The Coverdell Education Savings Account allows contributions of up to $2,000 per year for each child after tax deductions in the child’s name. These contributions must be non-deductible and must be in cash, but they will grow through tax deferral. Non-qualified withdrawals may be taxed, while funds withdrawn for qualified educational expenses will not be taxed.
Who can invest in a Coverdell Education Savings Account?
The Coverdell Education Savings Account is ideal for parents or grandparents who have some of the following factors:
- The desire to help multiple children attend college.
- Early college planning in the beneficiary’s life.
- Aspirations to save a significant amount in one go.
- Beneficiaries attending private elementary or secondary schools.
- A need for a high level of flexibility in investment options.
- Income below the maximum contribution limit ($110,000 for single filers, $220,000 for married couples in 2021).
Advantages and Disadvantages of the Coverdell Education Savings Account
Like any other investment, there are benefits and drawbacks to placing money in a Coverdell Education Savings Account.
Advantages of the Coverdell Education Savings Account
The main advantage of the Coverdell Education Savings Account is that it allows for tax-deferred growth of assets, as well as tax-free distributions for qualified educational expenses. Unlike 529 plans, which restrict how parents invest the funds, Coverdell Education Savings Account investors can choose to invest in any stocks, bonds, certificates of deposit, or mutual funds they believe will generate the greatest growth over their investment period.
Disadvantages of the Coverdell Education Savings Account
The biggest downside for parents and donors is the rule requiring you to either distribute the Coverdell Education Savings Account by the beneficiary’s 30th birthday or transfer it to another child. A 10% penalty will be applied to the withdrawn funds, and income tax will be imposed if the funds are not removed from the account (for example, if the beneficiary decides not to attend college or faces an emergency that prevents them from attending college). Parents can simply change the beneficiary to someone under 30 or roll the funds into a 529 plan to circumvent this outcome.
Note: It will be considered a “Qualified Distribution” if you decide to move funds from a Coverdell plan to a 529 plan, so income tax or penalty tax will not be applied.
What tax benefits can you expect?
You will not receive a tax deduction for placing money into a Coverdell Education Savings Account. Contributions are made after tax deductions. You will not reduce your tax bill in the year you make the contribution.
The significant tax advantage of the Coverdell Education Savings Account is that it allows for tax-deferred accumulation and tax-free withdrawal for qualified educational expenses. In other words, you do not have to pay tax on any annual growth of the original investment if the funds are used for education. Non-qualified withdrawals will be subject to taxes.
What are qualified expenses for the Coverdell Education Savings Account?
The owner of a Coverdell Education Savings Account can take a tax-free distribution on behalf of the beneficiary for qualified educational expenses. The IRS has generous criteria for what can be claimed as educational expenses, including:
- Tuition
- Tuition, housing, and food
- Computers and laptops (even if not required by the school)
- Books and supplies
- Tutoring
- Transportation
Coverdell Education Savings Accounts and Federal Financial Aid
A Coverdell Education Savings Account can significantly or minimally affect financial aid. Whether it does depends on who is designated as the “owner” of the account. The owner is the person who creates the account. They are not the person who will ultimately go to college. They are the “designated beneficiary.”
Here are some points to consider:
- No assets are counted against financial aid if the child is the owner and the designated beneficiary and is still considered dependent on their parents.
- If the child is the owner and the designated beneficiary and is considered independent of their parents, 20% of the assets are counted against financial aid. This percentage has decreased from 35% in 2007.
- If the owner is the parent, 5.64% of the assets are counted against financial aid.
- Assets are not counted against financial aid at all if the owner is a grandparent, extended family member, or unrelated person. This is due to the lack of a place to report assets owned by individuals other than the parents or student on the FAFSA form.
Note: Legislative changes in Congress can affect any of these guidelines at any time. This may include making Coverdell Education Savings Account assets count as parental assets or changing any of the other terms. Check with your financial advisor for the most current details and stay updated on developments if you decide to invest in a Coverdell Education Savings Account.
Contribution and Withdrawal Rules for Coverdell Education Savings Accounts
In addition to the adjusted gross income limits, there are a number of rules to keep in mind while contributing funds to a Coverdell Education Savings Account.
Contribution Rules
A Coverdell Education Savings Account for a child can accept contributions until their eighteenth birthday. The maximum annual contribution allowed is $2000 per designated beneficiary (not per adult contributor) each year.
Total contributions for any given year cannot exceed $2000 for all Coverdell accounts if the child has more than one account. For example, it might have been established by the parents, and another by a grandparent. There is no limit to the number of accounts a beneficiary can have, as long as the total contributions do not exceed
Source: https://www.thebalancemoney.com/beginners-guide-to-coverdell-esas-4060459
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