Families can save for college and K-12 expenses using a Coverdell Education Savings Accounts (ESA), previously known as Education IRAs.
Coverdell ESAs are less popular than 529 college savings plans, but have some advantages over them when saving for elementary and secondary school.
But are these advantages significant enough to make it worth your while to open a Coverdell ESA? Continue reading to learn the pros and cons of Coverdell Education Savings Accounts to help you decide.
Advantages Of Coverdell Education Savings Accounts
Coverdell Education Savings Accounts have a few advantages that can make them worth considering. Here are a few of their most noteworthy benefits.
More Qualified Education Expenses
Like 529 plans, Coverdell ESAs provide for tax-free distributions to pay for qualified education expenses. However, Coverdell ESAs have a broader list of qualified expenses than 529 plans and fewer restrictions.
While 529 plans can only be used to pay for up to $10,000 a year in K-12 tuition and fees, Coverdell ESAs don't have a limit on K-12 education expenses. Coverdell Education Savings Accounts can also be used to pay for things like academic tutoring, special needs services, uniforms, and more.
Eligible Institutions
Eligible institutions are the same for both Coverdell ESAs and 529 plans. They include any college eligible for Title IV federal student aid and any elementary or secondary school under state law, including home schools.
Broader Choice Of Investments
Investors in a Coverdell ESA have more control over the investments than investors in 529 plans. 529 plans are typically limited to a few dozen mutual funds selected by the plan administrator. Coverdell Education Savings Accounts can be invested in individual stocks and bonds. They cannot, however, be invested in life insurance contracts.
Disadvantages Of Coverdell Education Savings Accounts
Coverdell Education Savings Accounts are more limiting than 529 plans in several important ways.
Annual Contribution Limit
There is a $2,000 annual contribution limit per beneficiary. This is a combined limit that applies to all contributions from all sources to all of the beneficiary’s Coverdell ESAs. 529 plans do not have an annual contribution limit, other than the annual gift tax exclusion.
Excess contributions over $2,000 are subject to a 6% excise tax penalty unless they are withdrawn by May 31. Parents can learn about excess contributions made by relatives when they receive IRS Form 5498.
Taxpayers can choose to count contributions made by the due date on the federal income tax return, not including extensions, toward the previous year’s contribution limit.
Related: 529 Plan Contribution Limits
Beneficiary Age Limit On Contributions
Contributions to a Coverdell Education Savings Account must stop when the beneficiary reaches age 18, except for special needs beneficiaries.
Contributor Income Limit On Contributions
There is an income limit on contributions. The contributor must have an adjusted gross income that is less than $110,000 (single) or $220,000 (married filing jointly). The annual contribution limit starts being phased out at $95,000 (single) and $190,000 (married filing joint). These income limits are not adjusted for inflation.
There are workarounds for the income limit on contributions. Parents can gift the money to the child and have the child make the contribution to the Coverdell ESA. There is no requirement for the child to have earned income, unlike an IRA. Contributions can also be made from corporations and trusts without an income limitation.
Beneficiary Age Limit On Distributions
The Coverdell Education Savings Account must be fully distributed by the time the beneficiary reaches age 30, except for special needs beneficiaries. An alternative is to change the beneficiary of the Coverdell ESA to a member of the family of the current beneficiary, if the new beneficiary is under age 30.
Shared Provisions
Coverdell Education Savings Accounts share many of the same conditions as 529 plans. Here's a quick list:
Change In Beneficiary
The beneficiary of a Coverdell education savings account can be changed to a member of the beneficiary’s family, just as with 529 plans. But the new beneficiary must be under age 30.
Eligible members of the family include the beneficiary’s:
Spouses of any of the above members are also eligible to become the new beneficiary of a Coverdell ESA. Members of the beneficiary’s family also include first cousins, but not their spouses.
Related: How To Bypass The $2,000 Coverdell Contribution Limit By Changing The Beneficiary
Rollovers
Rollover contributions are not subject to the income limits or excise taxes. Rollovers are also not subject to contribution limits.
You can rollover from a Coverdell ESA to a 529 plan, but not vice versa. The 529 plan must have the same beneficiary as the Coverdell ESA. So, if the beneficiary is approaching the age 30 limit, one workaround is to rollover the money into a 529 plan.
Only one rollover is allowed per 12-month period. But you can do an unlimited number of trustee-to-trustee transfers. Rollovers must occur within 60 days if they aren’t made through a trustee-to-trustee transfer.
Coverdell ESAs can be transferred to the beneficiary’s former spouse as part of a divorce decree or separation agreement. Such a transfer is not taxable.
Final Thoughts
If you're looking to save for elementary, middle school, or high school tuition costs, a Coverdell ESA can be a strong choice. Unlike 529 plans, Coverdell Education Savings Accounts don't have annual limits on tax-free withdrawals for K-12 expenses.
However, 529 plans are likely to be more appealing to college savers since they have virtually no annual contribution limits. Coverdell ESA contributions, meanwhile, can't exceed $2,000 per year per beneficiary. That's pretty limiting when you're trying to save for expensive college tuition costs.
Still not sure which account you should choose? Learn more about your various education savings account options here >>>
Mark Kantrowitz is an expert on student financial aid, scholarships, 529 plans, and student loans. He has been quoted in more than 10,000 newspaper and magazine articles about college admissions and financial aid. Mark has written for the New York Times, Wall Street Journal, Washington Post, Reuters, USA Today, MarketWatch, Money Magazine, Forbes, Newsweek, and Time. You can find his work on Student Aid Policy here.
Mark is the author of five bestselling books about scholarships and financial aid and holds seven patents. Mark serves on the editorial board of the Journal of Student Financial Aid, the editorial advisory board of Bottom Line/Personal, and is a member of the board of trustees of the Center for Excellence in Education. He previously served as a member of the board of directors of the National Scholarship Providers Association. Mark has two Bachelor’s degrees in mathematics and philosophy from the Massachusetts Institute of Technology (MIT) and a Master’s degree in computer science from Carnegie Mellon University (CMU).
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