Coverdell Education Savings Accounts: A Deep Dive

While there are some limitations on income and contributions, as well as other restrictions, a Coverdell can be a bit more flexible than a 529 plan.

A college student works with a calculator and a tablet while sitting at table at home.
(Image credit: Getty Images)

Editor’s note: This is the third article in a six-part series focused on paying for education using smart financial and estate planning. Part one is Direct Tuition Payments: A Tax-Efficient Way to Pay for School. Part two is 529 Plans: A Powerful Way to Tackle Rising Education Costs. Future articles will focus on Uniform Transfer to Minor Accounts (UTMAs), education trusts and family loans.

It’s never too soon to start planning for the education expenses of a child, grandchild or someone you wish to support. With the cost of schooling on the rise — affecting everything from independent day schools to higher education — the need for strategic financial planning is more crucial than ever.

Fortunately, smart financial planning and estate planning can help manage these costs effectively.

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If you are planning ahead and weighing your options, you may want to consider opening a Coverdell education savings account. This tax-advantaged savings account, often compared to a 529 plan, offers greater flexibility in setup. Unlike a 529 plan, which is managed by the state where it’s based, a Coverdell can be established through banks, brokerage firms or mutual fund companies. Depending on the financial institution, you may find a greater variety of investment options than with a state-sponsored 529 plan.

Similar to a 529 plan, you contribute after-tax dollars to a Coverdell and invest inside the account, allowing the earnings on your investments to grow tax-free. Assets in a Coverdell are not included in the estate of the person who set it up. Withdrawals for qualified educational expenses (QEEs) are also tax-free. A significant advantage of a Coverdell over a 529 plan is that it can be used for unlimited expenses related to preschool, K-12 education or higher education, including fees, books, technology, certain room and board expenses and even academic tutoring. As is the case with a 529, any amount withdrawn for a non-QEE will be subject to income tax and a 10% penalty tax.

Contributing to a Coverdell

Compared to a 529 plan, there are significant limitations related to Coverdell contributions. The annual contribution per beneficiary is capped at $2,000 a year, regardless of who makes the contribution. Because each student is allowed to be the named beneficiary of multiple accounts, recordkeeping and communication become especially important. For example, if parents and grandparents both contribute $2,000 to different accounts for the same beneficiary in the same year, a penalty may be imposed on the beneficiary.

Additionally, there is an income limitation on those who can contribute to a Coverdell account. To qualify for the maximum contribution of $2,000, your annual modified adjusted gross income cannot exceed $95,000 for single filers or $190,000 for joint filers. This places a natural cap on who is eligible to open a Coverdell, whereas there is no income limit for a 529 plan.

Generally, the treatment of a Coverdell for financial aid is the same as it is for a 529 plan, meaning that if it is owned by the student or parent, it typically would be included as an asset on a student’s FAFSA (Free Application for Federal Student Aid) and thus may reduce the amount of aid given. However, a plan not owned by the parent or student may be treated differently.

Finally, you can contribute to a Coverdell account only for beneficiaries who are under the age of 18. When the beneficiary reaches the age of majority, typically 18 or 21, depending on the state, the beneficiary gains control over the account, and the Coverdell owner no longer has control over how the funds are used.

A Coverdell must be fully withdrawn by the time the beneficiary turns 30, providing a somewhat limited runway for use of the account. This could prove tricky for a student who defers graduate school or wishes to continue their education well into adulthood.

Rolling over a Coverdell account

To mitigate the limitations of a Coverdell, you can consider completing a rollover. One option is to roll over an existing Coverdell account into a different Coverdell account for another qualifying member of the family. For instance, if one child is turning 30, you can roll over the older child’s account into a Coverdell for a younger sibling who is still completing their education.

Alternatively, you may consider rolling a Coverdell into a 529 plan. Distributions from a Coverdell into a 529 plan are considered a qualified expense as long as both accounts have the same beneficiary. This may make sense if the beneficiary is approaching age 30 and is likely to use the funds at a later point in life. This option may also make sense if you are moving into a higher income tax bracket that will preclude you from making further Coverdell contributions, or if you (in conjunction with other family members) wish to contribute more than $2,000 to the beneficiary each year.

Once you have completed the rollover to a 529 plan, you have more flexibility to change the beneficiary to another family member without age limitations.

Benefits of a Coverdell:

  • Tax-free asset growth within the account
  • Greater flexibility related to qualified education expenses, especially for pre-college education
  • May be rolled over into a 529 plan or to another qualifying family member
  • Potentially more investment options through the sponsoring bank’s platform

Considerations to keep in mind:

  • $2,000 annual contribution limits
  • Income limitation for donors ($95,000 for single filers or $190,000 for joint filers)
  • The beneficiary gains control of the Coverdell at the age of majority (18 or 21)
  • Contributions are subject to federal gift tax laws and limitations
  • Contributions will be treated as gifts for federal gift tax purposes (but should not trigger the payment of gift taxes by the donor unless the total that the beneficiary received from the donor including gifts outside of the Coverdell account exceeds $18,000 in the year of contribution)
  • May reduce financial aid (student- or parent-owned Coverdells are included in FAFSA calculation)

Planning for education expenses requires thoughtful consideration and early action. Evaluating the benefits of a Coverdell alongside your other options can help you discover the most effective savings strategy for your family. With its flexibility to cover a wide range of educational costs and tax-free growth, a Coverdell offers notable advantages despite its contribution limits and income restrictions. Its suitability for pre-college expenses and the possibility of rolling over funds into a 529 plan enhance its appeal. By assessing these factors, you can craft a savings plan that aligns with your goals and secures a strong financial future for your child's education.

My next article will explore the educational savings benefits of Uniform Transfer to Minor Accounts (UTMAs).

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Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Denise McClain, JD, CPA
Director, Hirtle Callaghan

Denise is a Director at Hirtle Callaghan with responsibility for leading family relationships from our Arizona office. Denise brings over 26 years of her legal and financial experience working with multigenerational client families on all aspects of their financial lives. Denise draws on her past experiences to help clients develop and implement their wealth transfer plans and makes recommendations about wealth transfer and tax-saving strategies.