Coverdell Education Savings Accounts: Your 2024 guide

Dori Zinn

Key takeaways

  • Coverdell education savings accounts (ESA) are meant to help families put funds aside for elementary, secondary or college education expenses.

  • In general, Coverdell ESAs allow you to add $2,000 per year until your child is 18 — subject to income caps.

  • The main benefits for a Coverdell ESA include tax deferment, wider education uses than a 529, the ability for investments to grow and increased educational use options.

Saving for education can be a major stress point in your life. But a Coverdell account can help. A Coverdell education savings account is a custodial account designed to help someone save and pay for qualifying education expenses for dependents.

While Coverdell ESAs are similar to a 529 plan, there are also some differences in how they can help you save for your child’s college education. In general, these accounts are good for savers who are looking to save about a couple of grand per year and want more flexibility with the account.

If you’re planning to save for college and want to use a Coverdell ESA, make sure you know all the rules before setting one up.

How does a Coverdell education savings account work?

A Coverdell education savings account, or Coverdell ESA, is a savings plan for education-related expenses. Funds can be used for college, elementary or secondary education.

Like a 529 college savings plan, a Coverdell ESA offers some tax benefits, which you won’t get with a brokerage or traditional savings account.

If you’re looking to use a Coverdell ESA, follow these key steps.

1. Start your Coverdell ESA

You can create a Coverdell ESA for a beneficiary, typically your child, who is under 18 or has special needs. You can set up a Coverdell ESA at major financial institutions like a brokerage or mutual fund company.

2. Make contributions to the Coverdell ESA

You can contribute up to $2,000 per year until your child turns 18. The age limit does not apply to special needs beneficiaries.

The contribution maximum shrinks based on your modified adjusted gross income (MAGI), which is your gross income with certain expenses subtracted.

The limit is smaller if your MAGI is between $95,000 and $110,000 (or between $190,000 and $220,000 for joint filers). You can’t make any contributions if your MAGI is more than $110,000 (or $220,000 if you file jointly).

As you invest your contributions, they’ll grow on a tax-deferred basis.

3. Withdraw from the Coverdell ESA

Once your child is in school, you can take Coverdell education savings account withdrawals to cover qualifying education expenses tax-free. Be aware of the Coverdell withdrawal rules. Qualified expenses include:

  • Tuition.

  • Books.

  • Equipment.

  • Academic tutoring.

  • Special needs services.

If a disbursement exceeds qualified expenses, it can be taxed.

In addition to college expenses, you can also cover eligible K-12 expenses.

Pros and cons of a Coverdell education savings account

There are several reasons to consider opening a Coverdell ESA, but there are also some drawbacks.

Pros

  • You’ll have more control over your investment options than with a 529 plan.

  • Funds can be used for both K-12 and college expenses.

  • Coverdell ESAs can fund a wide range of investments, such as individual stocks, bonds, exchange-traded funds, mutual funds and real estate investments.

  • Contributions grow and can be withdrawn tax-free for qualified expenses.

Cons

  • You can only contribute up to $2,000 annually, and households with a higher income are excluded entirely.

  • You will face an excise tax if you contribute after your child has turned 18.

  • You’re subject to the Coverdell withdrawal rules. For instance, Coverdell ESAs cannot be used to pay for extracurricular activities.

  • The funds can’t sit in the account once your beneficiary turns 30. You’ll need to use the funds, roll them over to another ESA with a different beneficiary, roll over the funds into a 529 plan or change the beneficiary.

Is a Coverdell ESA right for me?

A Coverdell ESA isn’t for everyone. Here are some situations where it might make sense to use a Coverdell ESA instead of a 529 plan or another savings account:

  • You never plan to contribute more than $2,000 per year.

  • Your MAGI is below the phaseout threshold.

  • You don’t plan to make contributions after your child turns 18.

  • You live in a state that doesn’t offer additional tax benefits for 529 plan contributions.

  • You want to save for K-12 education expenses without limitations.

Consider your situation and compare all of your options before you decide which one to use to save for your child’s college education.

Coverdell education savings account withdrawal and contribution rules

A Coverdell ESA has specific contribution and withdrawal requirements. Here’s what you need to know if you want to avoid taxes.

Contribution rules

  • The account limits contributions to $2,000 annually. Additional contributions are subject to a 6 percent excise tax annually.

  • Your modified adjusted gross income could limit how much you contribute (or if you can contribute at all).

  • Contributions can be made only until the beneficiary turns 18 unless the beneficiary has special needs. After that, any contribution you make will be subject to the 6 percent excise tax every year.

Withdrawal rules

  • Funds must be used for qualified education expenses, from elementary up through college. Otherwise, you’ll face a 10 percent tax penalty, plus income taxes on the gains.

  • Any money left after the beneficiary turns 30 must be withdrawn within 30 days of their birthday unless the beneficiary has special needs.

What are the tax implications?

Contributions to Coverdell accounts aren’t tax deductible, but the earnings you gain on your investment grow on a tax-deferred basis. If your Coverdell education savings account withdrawals are for qualified education expenses, you won’t owe any taxes.

Any distributions you take beyond what’s qualified will be subject to a 10 percent penalty. You may also be subject to income taxes on the portion of your withdrawal that can be attributed to your gains. For example, if you contributed $5,000 and gained $15,000, only 75 percent of a nonqualified withdrawal will be taxable.

If you exceed the $2,000 annual contribution limit or put money in the account after your child reaches 18 years old — and they don’t have special needs — those funds are taxed. You’ll owe a 6 percent tax on those excess contributions each year that they remain in the account.

Also, the beneficiary only has until age 30 to use Coverdell ESA funds. Once they reach 30, the remaining account funds will be subject to a 10 percent penalty and income taxes on the gains.

The penalty and taxes may not apply if:

  • Your beneficiary has special needs.

  • You roll over the funds to a Coverdell ESA with a younger beneficiary.

  • You roll over funds to a 529 plan.

  • You change the beneficiary on the existing account.

What happens to funds left over from a Coverdell ESA?

There’s a chance that you may not use all the funds in your Coverdell ESA account. However, the account requires that you use up all the funds by the time the beneficiary reaches age 30 unless they have special needs.

If you have funds left over from a Coverdell ESA after your child completes their education, you have two options:

  • Roll it over: You can roll over unused Coverdell money to another account for an eligible family member or change the beneficiary for the current account. You can also transfer it to a 529 plan, a qualified distribution, to avoid the tax penalty.

  • Withdraw it: The funds must be withdrawn within 30 days of the beneficiary’s 30th birthday. Whether you use the money for qualifying education expenses, you must take it out of the account or risk losing it. If your distribution is not for qualified education expenses, plan to set aside some money for the 10 percent penalty and income taxes.

Coverdell ESA alternatives

You may decide a Coverdell ESA is not for you. For instance, if you want to contribute more than $2,000 per year or have too high of a MAGI, a Coverdell may not be the best option for your situation. Some other options to consider include:

  • 529 Plan: These are tax-advantaged savings plans. However, 529 plans may apply only to tuition and have a withdrawal cap of $10,000 per person per year for K-12 expenses.

  • Roth IRA: This is a popular retirement savings option famous for its tax advantages. You can take out earnings early for educational costs and avoid a bonus penalty with a Roth IRA.

  • Education tax credits: Look into educational tax credits and deductions that can help with the costs of higher education and school supplies. This option is subject to income limits, however.

  • Federal student loans: You can borrow and repay the amount you need for education costs with federal student loans. Some perks include potentially lower interest rates and borrower protections like income-driven repayment.

  • Private student loans: You can also take out education loans through private lenders. Private lenders may offer higher borrowing limits. However, private student loans don’t come with the same borrower protections as federal student loans.

The bottom line

While a Coverdell ESA is one college savings option, it’s not your only option. Before choosing a Coverdell account, make sure you qualify to open and contribute to one first. You can open up a Coverdell ESA with any brokerage or investment firm that offers them.

Compare your options to determine the right fit for you. Additionally, you’ll want to look at other college savings plans, including 529 plans, a brokerage account or a savings account. In some cases, it may even be worth it to use more than one.

  • Individuals whose MAGI is under the limit set for a given tax year can contribute to a Coverdell Education Savings Account.

    Organizations, such as corporations and trusts, can also contribute regardless of their adjusted gross income.

  • If the beneficiary dies before they are 30, the remaining funds must be distributed within 30 days.

    Most distributions are subject to income tax and may be subject to an additional 10 percent tax.

  • The ESA’s assets can be moved to a different financial institution with a tax-free rollover. To qualify, the account owner must provide an account statement or other documentation issued by the financial institution that acted as custodian of the ESA, showing the total amount contributed to the account and the earnings in the account. 

    The rollover must be accomplished within 60 days. A rollover may only be done once per 12-month period. The rollover may be completed for the same beneficiary or any other qualifying family member.

Advertisement