10/17/2017

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Coverdell Education Savings Accounts

If you know anybody who's ever heard of a Coverdell ESA, chances are you know a tax accountant. The Coverdell is one of the best-kept secrets in the tax laws. Once you get a sense of the benefits, however, you'll see why it's worth learning about.

Here's the deal. Anyone with an income of less than $95,000 ($190,000 for joint filers) may create and contribute the maximum to a Coverdell ESA for the benefit of any child under eighteen, and the account can be set up at virtually any bank or mutual fund. If your income exceeds the limit, you can make a contribution indirectly by giving it as a gift to the beneficiary, who then makes the qualifying contribution to his/her own account.

The maximum annual contribution is $2,000--not a lot, but contributing the max to a Coverdell doesn't prevent you from saving for college in other tax-advantaged ways (below). The contribution is not deductible from your taxable income. But the income the money earns within the account is never taxed by the federal government if it is used to cover the beneficiary's school expenses--be they for elementary school, high school, college, or vocational school. Most states never tax the proceeds, either.

The cash accumulating in the Coverdell can be invested in virtually any security--no life insurance, please. But the options are typically limited by the institution that's serving as the Coverdell custodian.

Change your mind about custodians? No problemo. You can roll over the money from one account to another (for the same kid) without tax consequences once a year. Or you can just set up a second Coverdell somewhere else--there is no limit to the number of accounts with one child as beneficiary, as long as the total annual contributions don't exceed $2,000. This latter approach can be problematic, though: custodians are free to charge fees to maintain Coverdells, and you probably won't want to pay fees to multiple institutions.

So what happens to the money if little Jessie decides to become a beach bum in Baja instead of a psychology major at Berkeley? You have the option of changing the beneficiary to one of Jessie's siblings.

Money can be taken out of a Coverdell at any time. No tax is owed as long as it is used for the beneficiary's tuition, books, room, and board. But the earned portion of money withdrawn from the account (in contrast to the principal) is counted as part of the beneficiary's taxable income if spent in other ways--and IRS adds a 10 percent penalty for good measure. Ditto for money that is not withdrawn by the time the beneficiary reaches age thirty.

Other noteworthy restrictions are:

  • Once money is in the Coverdell account, you can't take it back--it must be used on behalf of the beneficiary.
  • As the "responsible adult" designated in the account agreement, you have the discretion to maintain control of the funds until the beneficiary reaches age thirty, the point at which the account must be liquidated. Or you can transfer control to the beneficiary once he or she reaches age eighteen. But after control is transferred, the process can't be reversed.
  • A grandparent may set up a Coverdell, but the designated responsible adult must be a parent or guardian. And only the responsible adult can distribute funds or change the beneficiary.
  • The assets in a Coverdell count as part of the parent' assets in figuring eligibility for federal tuition aid.
  • The legal provision that qualified distributions for K-12 schooling expenses expires at the end of 2010 and may or may not be renewed by Congress.

Is the Coverdell ESA right for you? The accounts are simple to set up, but less flexible than the 529 plan and the U.S. savings bond approaches.

Where to Open a Coverdell ESA

As noted above, most banks and mutual funds are happy to set up Coverdell accounts and to do the minimal paperwork needed to maintain them.

This and more detailed information about Coverdell Education Savings Accounts can be found in Where To Put Your Money NOW by Peter Passell.

 

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