Coverdell Education Savings Accounts
The Coverdell Education Savings Account (also known as the Coverdell ESA) is a college savings option created by the federal government. It allows you to save money towards your child's college expenses with tax advantages. A Coverdell also offers one other benefit over other college savings vehicles: unlike the Section 529 plans, money in a Coverdell ESA can be used for educational expenses before your child is in college. You can take tax-free withdrawals from the account to help pay for expenses related to elementary, middle, and high school, such as tuition at a private school.
The Education IRA
Because the Coverdell ESA has certain similarities to an individual retirement account, or an IRA, it is sometimes referred to as the Education IRA. Each year, you can contribute up to $2,000 to your child's account. Just like with an IRA, these contributions are made with after-tax dollars — you've already paid income tax on the money that you're depositing into a Coverdell ESA. Through the investments you make with the funds in the ESA, your money will grow tax-free until your child is ready to start college. At that point, the money can be withdrawn without paying taxes, as long as it's used to pay for qualified educational expenses.
There are also eligibility requirements for opening a Coverdell ESA. If you file your taxes alone, your income must be under $95,000 in order to open an account. If you file as married, you and your spouse must earn less than $190,000. Grandparents can also open Coverdell ESAs.
Using a Coverdell ESA
You can establish a Coverdell ESA, naming your child as the designated beneficiary, as long as he or she is under the age of 18. Once the account is established, you can add contributions to it, although all contributions for the previous year must be made before your tax filing deadline. If a child has more than one Coverdell ESA — such as one created by a parent and another by a grandparent — the $2,000 limit to contributions covers all accounts.
When your child starts at college, you can take distributions from a Coverdell ESA to be used towards tuition, room, board, computers, books, tutoring, and even transportation. While the IRS requires you to use the money toward qualified educational expenses, the list of options is more flexible than with saving accounts like a Section 529 plan. Most colleges will take the money available in your Coverdell ESA into account when calculating financial aid for your son or daughter. However, as long as you are designated as the owner, a college will only count 5.64 percent of the assets in the account against financial aid, increasing the amount of financial aid your child can qualify for.
Once your child has completed college, you may find that there is still money in your Coverdell ESA. You can roll the account over to another family member who needs help with educational expenses. If you have two or more children, a Coverdell ESA can be an easier way to manage saving money because you can move the account over to another child if need be. Otherwise, all money must be distributed from the Coverdell ESA by the time your child reaches the age of 30.
The Future of Coverdell ESAs
The current legislation setting contribution limits for a Coverdell ESA is set to expire after 2010. At this time, it is unclear whether Congress will extend that legislation. If it is not extended, the limit on yearly contributions will fall to $500 a year, making Coverdell ESAs less useful when compared to other options, such as Section 529 plans.
There are a few other drawbacks that you should consider before opening a Coverdell ESA. If your child is older and will need money for college fairly soon, the $2,000 limit may not allow you save enough money in time to cover those college expenses. If, however, you are starting your college planning while your child is young, there will be enough time for that money to grow.