While 529 plans have higher funding limits and are a great way to save for college, the Coverdell education savings plan (ESA) offers more flexibility about what the funds can be used for, so parents may want to look into it as well.
To contribute to a Coverdell, parents must have a child under eighteen. The yearly limit for contributions per beneficiary is $2000.
There are also limits related to income. They are $190,000 to $220,000 modified adjusted gross income for married couples who file jointly and $95,000 to $110,000 for single parents. The maximum of $2,000 is gradually reduced when the income is between these limits, and if the modified adjusted gross income is above the upper limit, no contribution is permitted.
Because anyone can contribute, parents can give money to someone in a lower tax bracket, and that person can use the money to make the contribution. All contributors must coordinate gifts so that the ESA does not exceed the $2000 per year per child limit. WARNING: If gift givers go over the limit, a 6% excise tax is charged on the overage amount.
Some savings accounts require that the fund must be controlled by parents or legal guardians as the responsible individuals. That plan helps to ensure that all people who are contributing can be kept aware of the total contribution.
A parent and an ex-spouse can each establish separate ESAs.
Coverdell funds are not limited to college spending. They can be used for expenses for elementary, secondary, or higher education. The allowed expenses include tuition, books, fees, supplies, equipment, tutoring, purchasing computer technology, Internet access, room and board, uniforms, transportation, and extended-day programs that the school requires or supplies.
The contributions to a Coverdell are nondeductible. Growth on the money is tax-free, and withdrawals from the fund are tax-free up the beneficiary’s qualified expenses. The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution. This includes any public, private or religious school that provides elementary or secondary education as determined under state law. Eligible institutions also include any college, university, vocational school or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education.
Money that is withdrawn for expenses other than education is counted as the beneficiary’s income and is subject to a 10% penalty. If there is a balance in an ESA, it must be distributed within thirty days after a beneficiary reaches the age of thirty. The beneficiary would then be taxed on the earnings part of the contribution.
One caveat: If students are seeking federal financial aid, the Coverdell may be a liability because it is considered an asset for the student rather than the parent. The beneficiary may avoid these taxes by rolling over the full balance to another Coverdell ESA for another family member.
For more details, see IRS Publication 970, Tax Benefits for Higher Education (at IRS.gov), call 800-TAX-FORM (800-829-3676), or visit www.irs.gov/uac/Coverdell-Education-Savings-Accounts. Or contact your tax accountant and/or financial advisor.