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Saving for College – Coverdell ESA

As someone who is passionate about investing, I am a fan of Coverdell Education Savings Accounts (Coverdell ESAs).

A Coverdell ESA is a trust or custodial account set up in the United States solely for paying qualified education expenses. Qualified expenses may include tuition, fees, books, supplies, and equipment (e.g. computers and internet). If the student lives in housing provided by the school then room and board may also qualify. Contributions to Coverdell ESAs are not tax deductible but earnings inside an ESA grow tax free and distributions are also tax free as long as they go towards qualifying educational expenses. 

The primary advantage of a Coverdell account vs the more common 529 savings plan is the investment options available to a Coverdell account. Coverdell accounts can invest in individual stocks and bonds and have very few restrictions on investment options. These accounts can even invest in assets like real estate and crypto. 529 plans on the other hand are limited to a narrow range of funds chosen by the state sponsoring the plan. The difference between the accounts is similar to the difference between a traditional IRA (with nearly limitless investment options) and a 401K plan (where investment options are limited to those chosen by your employer). 

Parents that pay for private K-12 education may also benefit from a Coverdell ESA. ESA accounts don’t have the $10K withdrawal cap on K-12 tuition (and ESA accounts can pay for more than just tuition for the K-12 years too). In practice this isn’t likely to benefit many people though as it would be really difficult to contribute and grow an ESA account to sufficient size to contribute that much on an annual basis. 

Limitations and Drawback of Coverdell ESAs

  • Contributions are limited to $2K per beneficiary per year. 
  • Age Limit- No contributions allowed once a beneficiary hits age 18
  • Required withdrawal age- Balance must be fully withdrawn (or transferred to another family member) by the time the beneficiary turns 30
  • There is an income limit for those contributing to an ESA (but there is a workaround)

Income limits and Backdoor Coverdell ESA contributions

A phase out amount for contributions begins at a modified adjusted gross income level of $95K for individuals and $190K for married couples filing jointly. No contributions are allowed for individuals making over $110K or married couples filing jointly making over $220K. 

However, there is a backdoor way for higher earning parents to fund a Coverdell account. There is no earned income needed to contribute to a Coverdell ESA so a child can contribute to their own account. Parents can give their child the $2K needed to make their own Coverdell contribution (by setting up a UTMA account). The parent can then transfer that money from their child’s UTMA account to the Coverdell account. By following those steps parents essentially make a backdoor contribution to their Child’s ESA. 

A relative or friend can make a contribution on the child’s behalf (although the overall limit a beneficiary can receive is still $2K annually regardless of source). The key is that whoever contributes the money makes below the income limit. 

Contributions can also be made from corporations or trusts without an income limitation. 

What happens if a beneficiary doesn’t go to college or withdrawals are made for non qualifying expenses?

Beneficiaries will pay income taxes on the earnings portion of distributions from a Coverdell account if those distributions exceed qualified educational expenses.There is also a 10% federal penalty on those earnings withdrawn. Coverdell accounts can avoid tax and penalties by rolling over the full balance to another Coverdell ESA account for another family member. 

FAFSA & student aid

Coverdell ESA balances are considered assets of the account owner (not the designated beneficiary). Thus if a parent is the owner of the ESA account, under current rules 5.64% of the account would be considered available funds to pay for college. If a grandparent or third party is the account owner then the assets would not be reportable for financial aid applications. However, distributions from the ESA are then reported as untaxed income for the beneficiary on the following year’s FAFSA.

The Bottom Line

Coverdell ESAs are great accounts for those who like having more investment options. Even for those who want to take a passive index approach to their investments they can choose better options with lower fees in an ESA account than state sponsored 529 plans offer. The primary drawback vs a 529 plan is the $2K annual contribution limit along with the extra steps necessary for high income individuals to contribute. 

Scott Caufield, CFA, CPA