College Student Source: stck.xchng Photo: harrykeely

College Student Source: stck.xchng Photo: harrykeely

Earlier we discussed the 529 College Savings Plan as one option to save for college. Coverdell Education Savings Account (or Coverdell ESA for short) is another way of saving for a child’s college education. Coverdell Education Savings Account may be more familiar to us in its pre-2002 format, then called an Education IRA. However, since 2002 there have been changes to the plan that have made the program more attractive. The plan now includes coverage for certain elementary and secondary school expenses which is not available in a 529 College Savings Plan. It may make sense for families who wish to find a tax-advantaged savings vehicle to help pay for K-12 expenses to set up an Education Savings Account in addition to establishing a 529 College Savings Plan.

How does  an ESA work?

An ESA works similar to a Roth IRA. The account needs to be set up as a specially designated investment trust account to which non-deductible contributions can be made. The annual contribution limit is $2000 per beneficiary (was $500 prior to 2002 when it was called an Education IRA), which means if multiple people contribute to ESAs for the same child, you need to ensure that the total contribution does not exceed the annual contribution limits otherwise there are penalties. The contributions than grow tax free similar to a Roth IRA and withdrawals for qualified expenses are tax free as well. Contributions are not allowed once the beneficiary reaches the age of 18 and the account needs to be fully drawn before the beneficiary is 30 years old.

Who can contribute to an ESA?

Anyone with a modified AGI of $190,000 ($95,000 for single filers) can contribute to a Coverdell ESA upto the full $2000 limit. The contribution limit is slowly phased out above the $190,000. Above a modified AGI of $220,000 ($110,000 for single filers), you are no longer eligible to contribute to a Coverdell ESA.

However, you should note that there are no restriction on the type of relationship a contributor needs to have to the child. It is therefore possible for the child itself to contribute to the ESA account (if the child’s AGI is below the phaseout threshold). The child does not need to have earned income to contribute as is the case for IRAs. Which means that if you do not qualify to contribute due to income restrictions, you can make a gift to your child (subject to gift tax provisions) and the child can then make a contribution. Additionally, corporations can contribute to these accounts without having to worry about income limits.

Who controls the account assets?

Assets in a Coverdell ESA belong to the named beneficiary and the child has complete control over the assets once the child reaches the age of 18. Additionally, the assets are distributed to the beneficiary at the age of 30 if they are not completely used. A parent or the guardian of the child will likely be named the responsible person on the account (even if the contributor is someone else, say a grand parent) that will allow him or her to manage the account assets and in some cases even change the beneficiary on the account. However, the account assets cannot be refunded back to the parent or the contributor. In this respect, a 529 plan offers greater control and flexibility than an ESA.

What About Taxes?

All contributions are made with after-tax dollars and are deemed as a gift from the contributor to the beneficiary. Which means that the contributions are subject to the Gift Tax provisions and if you are contributing to a 529 plan as well you will need to make sure that you do not go over the gift tax exclusion limits (currently $13,000). All withdrawals are tax free if used for Qualified Higher Education Expenses (which currently also includes education expenses for K through 12 grades). If any part of the withdrawal is not used for qualified expenses, than the gains portion of the withdrawal is taxable along with a 10% penalty (contributions are never taxable). If in any given year, there are withdrawals from a Coverdell ESA as well as a 529 plan, than the Qualified expenses need to be allocated to these two plans to figure out the tax liability. Additionally, any tax benefit on a Coverdell ESA may be reduced if a Hope or a Lifetime Learning credit is also claimed in the same year.

Certain benefits may expire after 2010

Unless Congress acts, certain benefits of a Coverdell Education Savings Account will expire after 2010. The annual contribution limit will revert back to $500 from the current $2000. K-12 expenses may not be eligible after 2010. Additionally, withdrawals will not be tax free in any year in which Hope or Lifetime Learning credit is claimed for the beneficiary. Therefore if you are planning to set up an ESA now, you need to be aware of the potential erosion of benefits

Overall, a Coverdell Education Savings Account provides a good way to save money for college for your child but the low contribution limits, eligibility phaseout with income, tax coordination headaches, lack of control, etc make a 529 College Savings Plan a vastly superior option. You should always consult your financial advisor as a Coverdell ESA will make sense in certain situations.

Shailesh Kumar

Shailesh Kumar

Shailesh Kumar is an Entrepreneur, investor and blogger. He writes about value investing at Value Stock Guide. Learn about the stock market and discover the techniques proven to work best for long term investors for finding appropriate stocks to buy in their portfolio to get superior risk adjusted returns.