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What Is a Coverdell Education Savings Account?

The UMe Emu with a graduate hat on besides the words "What is a Coverdell Account?"

If your child isn’t pursuing a degree in winning the lottery, you can likely count on big costs for college. Fortunately, UMe’s Coverdell Education Savings Account (Coverdell ESA) is designed to help U and your family. It’s the college savings account that sets your child up for success!

Formerly called an “Education IRA,” a Coverdell ESA  is an education account that accumulates interest tax-free! Saving for college is why many people open and use a Coverdell ESA, the account is also available for use toward eligible K-12 expenses.

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A Coverdell ESA is a tax-advantaged trust or custodial account that is designed to be used to save for educational expenses. Contributions to Coverdell accounts can total up to $2,000 per year and are tax-deferred, which means that any growth in the account would not be subject to income or capital gains taxes when the beneficiary takes money out — if it goes toward qualified educational expenses. Account holders are also eligible to withdraw money from this account without penalty.

How a Coverdell ESA works

There are several rules and stipulations for who is eligible to open a Coverdell ESA and how much they are able to contribute.

Eligibility

To open a Coverdell education savings account, you must meet certain criteria. The IRS’ stipulations include:

  • The designated beneficiary for the Coverdell must be under 18 years old. There can be exceptions to this rule if the beneficiary has special needs.
  • The account has to be defined as a Coverdell ESA on the day it is opened.
  • The documents used to open and establish the account have to be in writing.

Contribution limits

You can have more than one Coverdell account for a beneficiary, but the total contribution to all accounts cannot exceed $2,000 per year. Similar to the rules concerning individual retirement accounts, you can make your annual contribution to an ESA up until the tax filing deadline for that year.

There are certain limits on who can open a Coverdell account, and they depend on your modified adjusted growth income (MAGI) and your filing status:

  • If you file your taxes jointly and your MAGI is under $190,000 per year ($95,000 for single filers), you’re eligible to contribute the full amount.
  • Those with a higher MAGI will see the amount they can contribute reduced.
  • And if your MAGI is above $220,000 per year ($110,000 for single filers), you aren’t eligible to contribute to a Coverdell ESA.

Distributions (A.K.A. Withdrawals)

Generally speaking, the beneficiary of a Coverdell ESA will be able to draw money from the account tax-free, as long as the money is put toward qualified educational expenses. The range of what qualifies is fairly broad: Qualified expenses include tuition, fees, books, computer equipment and technology required for elementary, secondary and post-secondary education. Additional qualified expenses can be found on the IRS website.

Nonqualified distributions are taxable to the beneficiary, along with a 10% penalty, so it’s essential to understand whether an expense will qualify before taking money out. If you’re unsure about whether a distribution meets the criteria, you may want to consult with a tax advisor to avoid making a costly error.

Any remaining funds in a Coverdell ESA must be distributed by the time the beneficiary of the account turns 30 (again, there are exceptions if the beneficiary has special needs). If the distribution at age 30 doesn’t qualify as an educational expense, the taxes and 10% penalty will apply to the account’s beneficiary. However, you are allowed once a year to change the beneficiary of a Coverdell account to another family member.

Is a Coverdell ESA right for me?

Opening a Coverdell ESA might be a great fit for you and your family, depending on your financial situation. If you’re looking for tax-deferred savings toward educational expenses with more flexibility regarding your investment choices, then a Coverdell just might make sense for U!

If you’d like to contribute more than $2,000 per year toward educational savings, there are other options available, in addition to a Coverdell.  As always, it’s best to consult with your tax professional and/or financial advisor before making a selection on the best fit for you. If you have any questions, please give us a call at (818) 238-2900 or email us!

 

 


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