How it Works: Everything You Want to Know About Coverdell ESA's
A Brief History
Established, along with the Roth IRA, with the Taxpayer relief act of 1997, Education IRAs were created for funding higher education. To give families some tax advantages to combat the skyrocketing cost of most universities. The first iteration of the education IRA failed to take off due to low contribution limits, only $500 per year and only being available for Higher Education. In 2002 it was renamed the Coverdell ESA, had the contribution limits raised to $2,000 per year and extended the definition of "qualified expenses" to cover grades K-12.
How it works
An ESA can be opened by anyone, but they have to be for the benefit of a minor child. Contributions are made on an after-tax basis and are subject to income limits. You're MAGI must be below $95,000 filing single or $190,000 filing married to be able to make the full $2,000 contribution. Fully "phasing out" at $110,000 filing single or $220,000filing married Much like an IRA an ESA can be invested in almost anything with stock, bonds, or mutual funds being the most common. The contributions grow in the account on a tax-deferred basis and, if used for qualified educational expenses, can be withdrawn tax-free. Qualified educational expenses include books, tuition, supplies and equipment, and certain room and board expenses.
Contributions are no longer allowed after the beneficiary reaches the age of 18 and must be used by the time the beneficiary reaches the age of 30. If the funds are not used for "qualified educational expenses" then there is a 10% penalty on the earnings for withdrawing the money. The $2,000 contribution limit is low and most likely would not cover a full 4 years at a university. A portion of the total assets in a Coverdell will be counted as "expected family contributions" when applying for a student loan, currently at 5.56%
Although a Coverdell has to be managed by one person, usually a parent or guardian, contributions can be made by anyone. Giving grandparents and other family members a chance to contribute as long as the combined amount does not exceed $2,000. If the original beneficiary does not use all the money, then that money can be rolled over to another beneficiary as long as that beneficiary is an immediate family member, which extends to 1st cousins.
Is it right for me?
The Coverdell can be a good tool if your goal is to fund a portion of educational expenses or if you want a good place to put cash gifts from family members. A fully funded Coverdell, even earning a decent interest rate, will not cover the cost of the average four-year university. If fully funding a child's education is your goal, then a 529 might be a better option, especially with the changes made in 2017 allowing a portion of the assets to be used for grades k-12. Which essentially makes the Coverdell obsolete.