Consumers have had an excellent opportunity to help pay for their children’s educational expenses by contributing up to $2,000 a year to Coverdell Education Savings Accounts (ESAs). Contributions, though not tax deductible, grow tax deferred and withdrawals to pay for qualified educational expenses from kindergarten through college are tax free. Covered expenses include: tuition, room and board, computers, extended day programs, academic tutoring, equipment, uniforms, and transportation.
The beneficiary of the account must be under the age of 18 at the time of the contribution. There is no requirement that the beneficiary be your child or have any other particular relationship. Also, your income must be below a certain level in the year of your contribution. Contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution. The $2,000 maximum is gradually phased out if your modified adjusted gross income falls between $190,000 and $220,000 ($95,000 and $110,000 for single filers). You can contribute to both a 529 plan and an ESA for the same beneficiary if you wish. However, besides the $2,000 annual limit on how much you may contribute for a particular child, there is also an overall $2,000 annual limit on contributions to ESAs for the benefit of that particular child in a given year.
There are a number of other restrictions with ESAs. First, beneficiaries of the accounts must be under age 18 when contributions are made, and the money can only be used for the beneficiary. Second, no refunds are available to the person who initiates the account. Third, if the beneficiary reaches age 30 without using the money, it will be distributed to the beneficiary and become taxable. However, the person who set up the account can change the beneficiary at any time to another family member under age 30.
Contributors to ESAs can select their own investments. Unlike 529 Savings Plans which limit investor choices to a limited menu of investments, the only investment prohibited for Coverdell accounts is life insurance. Never the less, financial institutions that offer Coverdell accounts can set their own investment restrictions. For example, Charles Schwab Investments does not allow risky and often illiquid investments such as coins and antiques. Schwab also disallows other exotic investments like futures contracts and other financial derivatives from Coverdell accounts.
Again, unlike 529 Savings Plans that limit changing investments to once a year, ESA contributors can switch among investments as often as they like. Though switching investments often can be costly, it’s a nice have that option. Speaking of costs, be careful of firms’ set up charges and annual fees to maintain an account. With ESAs’ relatively low contribution limits, even a modest $25 annual fee can cut deeply into returns.