Understanding Coverdell Education Savings Accounts

Family Finances, Planning & Saving
on September 26, 2013

With the passage of the American Taxpayer Relief Act of 2012 ensured that the Coverdell Education Savings Account would continue to be a viable option to pay for future school expenses. The Coverdell ESA is a type of financial account opened through a bank or a brokerage, usually after the account holder has also considered the somewhat similar section 529 qualified tuition plan.

The most obvious advantage of the Coverdell ESA is that it can fund elementary and secondary education expenses in addition to college expenses. The designated beneficiary must be under the age of 18 at the time contributions are made, so account balances intended to pay college expenses are fully funded well ahead of actual expenditures. Contributions are not tax-deductible, but subsequent account earnings are tax-deferred and are optimally tax-free.

A Coverdell ESA beneficiary must close the account and pay tax if any balance remains upon reaching age 30, so the tax advantage is to utilize the account balance to the greatest extent before that age. Amounts withdrawn over the years to pay qualifying education expenses are likely to include earnings that have accumulated tax-free.

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Qualified expenses for elementary and secondary students can include room and board in addition to tuition. Public, private and religious schools all qualify. Higher education expenses are subject to somewhat tighter restrictions. A student must be enrolled on at least a half-time basis for room and board to be an additional qualifying expense. Other tax-free educational assistance received, such as scholarships and grants, are first subtracted from total qualifying educational expenses to calculate the corresponding reduction in the Coverdell ESA account balance.

The Coverdell ESA cannot be fully evaluated without contrasting it with the section 529 plan option. Many states sponsor section 529 plans, and individuals do not have to use the plan within their own state of residence. The annual Coverdell ESA contribution limit is $2,000 while the section 529 limit set by each state is usually much higher. The Coverdell ESA has income restrictions for contributors while the section 529 has none. The section 529 has no age restrictions and is for post-secondary expenses only.

Many states provide a state income tax advantage for holders of their specific section 529 plan. The account contribution might be treated as an adjustment, reducing taxable income on the state return.

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