There is yet one more option out there – the Coverdell Education Savings Account (ESA).
Coverdell ESA’s (formerly called “Education IRA’s”, later renamed after the late Senator Paul Coverdell, who was their primary backer) have taken a back seat to 529 plans in recent years as their contribution limits were expected to drop. The fiscal cliff deal, however, has breathed some new life in to them, and if you have children, it’s at least worth knowing what they can do and how they differ from 529’s. I’ll get in to the fundamental differences, but will first cover the basics on how they work.
What is a Coverdell Education Savings Account?
At its most basic level, Coverdell ESA’s are self-directed custodial investment accounts that can be used to pay for qualified education expenses.
Coverdell ESA’s are not tax-deductible, but earnings grow tax deferred, and distributions are tax-free so long as they are used for qualified education expenses.
In a number of ways, they closely resemble Roth IRA’s – both are after-tax, grow tax-deferred, have contribution limits, and are self-directed.
Coverdell Contribution Limits
As with all tax advantaged accounts, there are annual contribution limits.
The fiscal cliff deal extended Coverdell contribution limits of $2,000 annually (they were set to roll back to $500).
Contribution deadlines work just like IRA deadlines – you can contribute starting Jan. 1 in a calendar year up until the tax deadline for that year. For example, you could contribute $2,000 for 2017 and another $2,000 for 2018 up until April 15, 2018.
Note that Coverdell contributions are separate from 529’s (much like the maximum 401K contribution is separate from maximum IRA contribution). In other words, you can contribute to both and they are not tied to each other.
Coverdell Advantages Vs. 529’s
If you’re choosing between the two, Coverdell’s have two major advantages over 529 plans:
- Self-directed: Coverdell’s are self-directed, whereas 529 plans are limited to the state’s selected investment options (much like an employer has limited investment options in a 401K). Coverdell’s are like IRA’s – you invest in whatever you want to. For amateur investors this might be intimidating, but if you are a cost-conscious investor (i.e. commission-free ETF’s or low-cost index funds), Coverdell’s might make more sense.
- Primary school expenses: Coverdell’s can be used to cover expenses at primary and secondary schools (basically anything before college), as well as post-secondary, whereas 529’s can only be used towards post-secondary. This is a big benefit for those with children that generate significant expenses in their pre-college years. Expenses could include tuition, uniform, tutoring, books, supplies, and even technology (i.e. computers).
529 Advantages Over Coverdell’s
529’s have a few key advantages over Coverdell’s:
- Contribution limit: The $2,000 annual maximum is much lower than 529’s, which often don’t set limits (varies by state). The money you put in a 529 account is considered a gift and, as such, qualifies for the annual $14,000 (2017) gift tax exclusion. That is, you can contribute up to $14,000 annually (or $70,000 if you carry forward for the next 4 years), per beneficiary, without incurring any gift tax. You can contribute more, but you would incur the gift tax. For more on this topic, check out IRS publication 559.
- Income limit: In order to contribute, Coverdell’s have an income limit for the contributor, while 529’s do not. Once your adjusted gross income is over $220,000 as a married couple or $110,000 for other taxpayers, you can’t contribute to a Coverdell.
- Tax credits and deductions: If your state offers a state income tax deduction or credit for contributions to its 529 plan (as many do) you should definitely take advantage of that prior to putting any money away in a Coverdell (as they do not offer state benefits).
- Age limit: Coverdell balances must be spent by age 30 or taxes and penalties could apply. They can, however, be transferred to another beneficiary or rolled in to a 529 plan. 529’s have no age limit.
Coverdell Vs. 529 Comparison
Here is a chart that compares Coverdell’s to 529 plans.
|Coverdell ESA||Prepaid Tuition 529||529 Savings Plan|
|How it Works:||Self-directed investment account (similar to an IRA). You can contribute and withdraw at the time the benefactor has education costs.||You pay now for future education. Price of tuition is locked in at today's prices at participating institutions.||Works more like an investment account where you can contribute and withdraw at the time the benefactor has education costs. Investment choices limited to state selections.|
|Tax Benefits:||Not tax deductible at state or federal level. Earnings & withdrawals are tax-free if used for qualified expenses.||Not tax deductible at federal level, but is deductible for some states.||Not tax deductible at federal level, but is deductible for some states. Earnings & withdrawals are tax-free if used for qualified expenses.|
|Expenses it can be Used Towards:||All qualified education expenses, including tuition, room & board, mandatory fees, books, & computers for primary, secondary, and post-secondary education.||Tuition & mandatory fees. Some plans allow you to pre-purchase room & board or use excess tuition credits for other qualified expenses. For post-secondary only.||All qualified education expenses, including tuition, room & board, mandatory fees, books, & computers. For post-secondary only.|
|State Residency Requirement:||N/A.||In most states, residency is required.||State residency is not required, although there may be additional benefits (i.e. state income tax deduction) by purchasing in state.|
|Performance/Guarantees:||Results are self-directed.||Most are backed by state government.||Results vary based on market performance.|
|Age Limits:||Must be used by age 30, or transferred to another beneficiary or a 529 plan.||Most have an age limit.||No age limits. Beneficiary can be any age.|
|Contribution Limits:||$2,000 per student per year.||Depends on state plan.||Depends on state plan, but usually high.|
|Income Limits:||Once your adjusted gross income is over $220,000 as a married couple or $110,000 for other taxpayers, you can’t contribute (2017).||No income limits for contributors.||No income limits for contributors.|
|Availability:||Nation-wide. Not affiliated to states.||12 states||50 states|
Why Not Contribute to Both a Coverdell and a 529?
There is no law that prevents you from contributing to both a Coverdell and a 529.
My take? I’d try to get the full state tax benefit (if available in your state) for 529 contributions before contributing to a Coverdell. If your state doesn’t offer those tax benefits, then it might make more sense to max out your Coverdell contributions prior to contributing to a 529. You can always move your contributions over to a 529 at a later point in time, if you’d like, so there is no downside. And the upside is you get to invest in whatever you’d like, and ideally at a lower cost.
Coverdell ESA Discussion:
- Have you invested in a Coverdell for a child? Why or why not?
- Do you think you will invest in a Coverdell, in addition to a 529?