Coverdell Education Savings Account (ESA): Detailed Guide

It's no secret that students in the United States are drowning in debt. In 2020, student debt was anticipated to be $1.7 trillion, and this figure is expected to rise. 1 In 2019 and 2020, the average cost of a full-time undergraduate in the United States was $20,598 for a public, in-state, four-year university and $26,382 for a public, out-of-state, four-year institution. 2 A Coverdell Education Savings Account is an option for parents, grandparents, and other family members who wish to get an early start on paying for their children's college education (ESA). It's vital to understand the finer points of this long-term savings strategy, just like it's important to understand the finer points of any investment, and this beginner's guide is a great place to start. Consult a financial advisor for the most up-to-date information and individualized assistance in determining whether the Coverdell ESA is best for you.

What Is a Coverdell ESA and How Does It Work

A Coverdell ESA lets you make after-tax contributions in the name of your child up to $2,000 per year. These non-deductible contributions must be made in cash, but they will grow tax-free over time. Non-qualifying withdrawals may be taxed, but money taken out for approved school expenditures is not. The tax is paid by the recipient. This benefit is available for both qualifying higher education and qualified primary and secondary school expenses. To establish a Coverdell ESA, you must meet the following requirements:

At the time the account is formed, the specified beneficiary must be under the age of 18 or a special-needs beneficiary.
When the account is created, it must be labeled as a Coverdell ESA.
The account must be created and governed by a written document that complies with IRS rules for the year in which it is established.
If the money isn't utilized by the child's 30th birthday, it must be donated to them or rolled over to another family member's Coverdell ESA.

Investors who would be good candidates for a Coverdell ESA

A Coverdell ESA is excellent for parents or grandparents who have several of the following characteristics:

a desire to assist several children in attending college.
Early on in their beneficiary's life, they had foresight in arranging for college.
desire to save a significant sum of money at one go.
Beneficiaries are students who attend private elementary or secondary schools.
Demand a lot of freedom when it comes to investment options.
In 2020, income below the contribution limitations ($110,000 for single taxpayers, $220,000 for married couples)

Potential Benefits

A Coverdell ESA's main benefit is that it enables tax-deferred asset growth as well as tax-free payouts for eligible educational expenses. Unlike Section 529 plans, which restrict how parents can invest their assets, Coverdell ESA investors can invest in whichever equities, bonds, CDs, and mutual funds they believe will provide the best long-term growth. 5

Possible Negative Repercussions

The requirement forcing you to either disperse the Coverdell ESA by the time the child turns 30 or roll it over to another child is the largest drawback for parents and donors. If the funds are not taken from the account, they will be pushed out with a 10% penalty and income tax will be required (for example, if the beneficiary decides not to attend college or suffers an emergency that prevents them from doing so). To avoid this outcome, parents can simply change the beneficiary to someone under the age of 30 or move funds to a Section 529 plan. If you move assets from a Coverdell to a Section 529, it will be considered a "qualified distribution," which means no income tax or penalty tax would be owed.

What Kind of Tax Savings Can You Expect

You won't get a tax break if you contribute to a Coverdell ESA. After-tax dollars are used to make contributions. They will not reduce your tax bill in the year you make the contribution. The Coverdell ESA has a significant tax advantage in that it provides for tax-deferred growth and tax-free withdrawals for eligible expenses. In other words, if the money is utilized for education, you won't have to pay taxes on any of the annual growth of your original investment. Non-qualified withdrawals, on the other hand, will be taxed.

What Are Coverdell ESA Eligible Expenses

For approved educational expenses, a Coverdell ESA owner can take a tax-free distribution on behalf of the beneficiary. The IRS sets lenient guidelines for what can be claimed as an educational expense, which include:

Tuition, lodging, and board are all included in the price of the program.
Laptops and computers (even if not required by the school)
Books and materials
Tutoring
Transportation

Federal Financial Aid and the Coverdell ESA

Coverdell ESAs can have a big or little impact on financial aid. It depends on who is listed as the account's "owner." "The account's owner is the person who creates it." It isn't the individual who will attend college in the future. They've been identified as the "beneficial recipient."

Here are some things to think about

If the child is both the owner and the designated recipient of the assets and is still regarded as a parent's dependent, none of the assets are assessed against financial aid. If a child is both the owner and the designated beneficiary of an asset and is considered financially independent of his or her parents, 20 percent of the asset is deducted from financial aid. This is a decrease from the previous year's figure of 35%. If the owner is a parent, 5.64 percent of the assets are taken into account when determining financial aid eligibility. If the owner is a grandparent, a member of the extended family, or an unrelated individual, the assets do not count against financial help. This is because there is no space on the FAFSA form to list assets owned by anyone other than a parent or a student. Any of these general concepts can be affected or changed by legislation in Congress at any moment. This could include converting the Coverdell ESA to the parents' assets or altering any of the other provisions. If you decide to invest in a Coverdell ESA, check with your financial advisor for the most up-to-date information and keep up with the latest changes.

Contribution Restrictions

Contributions to a child's Coverdell ESA can be made up until the age of eighteen. The maximum annual donation per designated recipient (rather than per adult contributor) is $2,000 per year. If a child has more than one Coverdell account, the total contributions for that year cannot exceed $2,000 for all of them. One might have been started by their parents, while the other by their grandmother. A beneficiary can have as many accounts as he or she wants, as long as the total contributions for the year don't exceed $2,000. Individuals whose "modified adjusted gross incomes" (MAGIs) are below a specific dollar amount in the year they contribute can make the full $2,000 payment. If their income is more than this but less than the "limit," they can make a partial contribution.

For taxpayers who claim single, head-of-household, or married-filing-separately status, the following limits apply

If your MAGI is less than $95,000, you can make the entire $2,000 payment.
A partial contribution is allowed for MAGI of $95,000 to $110,000.
No contribution is allowed if your MAGI is more than $110,000.

The following are the limits for taxpayers who claim married-filing-jointly status

If your MAGI is less than $190,000, you can make the entire $2,000 payment.
A partial contribution is allowed for MAGI of $190,000 to $220,000.
No contribution is allowed if your MAGI is more than $220,000.

The Deadline for Submissions

Contributions to a Coverdell ESA for the previous year, excluding extensions, must be made before the contributor's tax-filing date. Even if you file an extension with the IRS, you normally have until April 15 to make a donation for the prior tax year. Several tax deadlines for the 2020 tax year have been extended by the IRS. Individual tax reports, tax payments, retirement account contributions, and Coverdell ESA contributions have all been postponed until May 17, 2021. Contributions for the 2020 tax year must be made by June 15, 2021, for residents of Oklahoma, Louisiana, and Texas. As a result of the catastrophic winter storms expected in 2021, their tax-filing date has been extended.

Rules for Withdrawal

Withdrawals made to support educational expenses are tax-free and penalty-free as long as the withdrawal does not exceed the actual amount of expenses. If funds are withdrawn in excess, a portion will be subject to taxation and penalties. Unless the specified beneficiary is a special-needs beneficiary, any residual assets in the account must be distributed when he or she reaches the age of 30. In this instance, the funds can be kept in the account for a longer period of time.

Unused funds are handled in a special way

The money can be moved into another Coverdell ESA for someone under the age of 30 who is related to the original recipient. Immediate family members of the original beneficiary, parents, cousins, aunts, uncles, and even in-laws are all considered related parties.