Advantages and Disadvantages of a Coverdell Account (ESA)

About Coverdell Education Savings Accounts

A Coverdell account is an Education Savings Account (ESA) that has certain advantages and disadvantages over ordinary savings accounts or 529 plans often used to save money for college.

A Coverdell savings account was established as an incentive for people to save money for a minor's education expenses at a nearby bank or financial institution and to enjoy tax-free earnings on the deposited funds as long as the money is used to pay for qualified education expenses.

Graduation comes quickly. It's never too early to start investing for future education expenses.
Graduation comes quickly. It's never too early to start investing for future education expenses. | Source

Coverdell ESA vs. 529 Plan

Recently, the 529 plan has become a very popular savings vehicle for education expenses, with its higher contribution limits and state-sponsored plans. In fact, a 529 and ESA like the Coverdell serve the same purpose - saving a pile of money for education. However, there are some key differences that differentiate the two. Here are the major differences:

Differences Between a 529 and Coverdell Account

Attribute
529
Coverdell
Contribution Limit
No exact limit
$2,000 per year
Approved Uses
Higher Education
Primary Schools or Higher Education
Allowed Investments
Minimal Choices Set by Plan
Virtually Unlimited
Must Be Used By
No Age Limit
Student's 30th Birthday
There are several other differences, but these are the most significant among them.

What Can Coverdell Money Be Used For?

Higher Education

  • tuition
  • fees
  • books
  • school supplies
  • necessary equipment
  • room
  • board

Elementary or Secondary School

  • tuition
  • fees
  • books
  • school supplies
  • necessary equipment
  • tutoring
  • room
  • board
  • uniforms
  • transportation
  • computer
  • internet access

These items must be required for the student to attend the school, and some special rules apply, of course.

Advantages of a Coverdell ESA

Easy to Open

This type of account is easy to find at a host of banks and very simple to open. Even online Coverdell ESA accounts are available and can be opened and funded within minutes. Because many banks have this option, your local bank may as well. That means you can save where you bank, right in your hometown. For many savers this is comfortable and easy.

Flexible Investments

For those who want total control over what they invest in, a Coverdell is much more flexible than a 529 plan. A typical 529 plan has a small number of portfolios that you can select form and that's it. With a Coverdell, the world is your oyster. Virtually any typical mutual fund, ETF, stock or bond may be used as an investment. This really allows the owner to be an active investor, or for a financial adviser to help out.

More Education Options

Unlike a 529, from which money can only be used for college and beyond, the Coverdell ESA permits money to be used for qualified expenses related to elementary or secondary schools. That means when junior is born you can start saving for private school in this account.

Tax Free Earnings

This is really the point of the account. Money that goes into the ESA is considered to be "after tax". That means Uncle Sam sees this money as having already been taxed. Therefore, when the money is distributed and used for a qualified education expense, all of those earnings over the years will not be taxable either. This makes a huge difference in the ending balance over a long period of time.

Student Loan Factor

The balance in the ESA is considered to be the owner's money, not the student's - so long as they are not one in the same. That means a parent or grandparent's funding of the account won't end up counting as assets of the student when applying for a student loan, and that's a good thing.

Funding a Coverdell ESA and 529 Together

One idea for those wanting the flexibility of the ESA but who would like to put away more than the contribution limit is to first fully fund the ESA, then deposit the excess into a 529 plan. Here, you get the best of both worlds.

Disadvantages of a Coverdell ESA

Low Contribution Limit

Unlike the 529 plan, the ESA comes with a catch. You can only deposit $2,000 per year per beneficiary into the account. It doesn't matter if you open a second one at another bank either. That $2,000 applies to the beneficiary, not the account. While this may be more than enough for young parents, some may find this to be very limiting. If that's the case for you, it is a viable option to fully fund the Coverdell each year and put the rest in a 529 plan.

Age Deadline

Funds in the account must be used by the student's 30th birthday or the money becomes taxable. This may be no big deal for many, but could be huge for others for whom this age will be reached. One way to avoid the tax is to transfer the beneficiary in the account to another, younger, student. But, of course, that means the intended recipient loses out. A 529 plan has no such age limit.

Adjusted Gross Income Limit

In order to fund a Coverdell account, the depositor must be under the AGI limit. This limit is $110,000 for a single filer and $220,000 for those that file a joint tax return. That is not exactly a limiting amount for many people, but for those with an AGI in this neighborhood or beyond it may be a deal breaker.

Is a Coverdell ESA Worth It?

If you are trying to determine whether or not to open a Coverdell account, hopefully these advantages and disadvantages will help you to decide. If investment flexibility, the ability to save at your bank or use the proceeds for expenses other than higher education are important to you, a Coverdell ESA makes a lot of sense.

Tax free earnings in a Coverdell Education Savings Account can drastically outperform the piggy bank, so it's a good idea to start investing early.
Tax free earnings in a Coverdell Education Savings Account can drastically outperform the piggy bank, so it's a good idea to start investing early. | Source

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