Taking A Second Look At The Coverdell ESA For K-12

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Happy Plate at Guy Savoy Restaurant

When each of our children were born we started a 529 plan within months of their birth.  We never even really considered another way to save for college and the 529 savings plan is still probably the best way to save for college for most high income earners.  But lately I find myself taking another look at the Coverdell Education Savings Account (ESA), not as a college savings plan but for use during my kids’ time in grades K-12.  I’m always on the look out for the most cost-effective way to manage our money.  Hence my love for the flexible spending accounts, healthcare and dependent-care.  I had heard of the Coverdell several years ago, but it sounded uninteresting and unuseful for us.  But I’m starting to see that the Coverdell ESA may be yet another way to save on education expenses we’d have to pay for anyways and suddenly it’s not so uninteresting to me anymore!  Additionally, any extra money left in the Coverdell ESA after my kids finish high-school could be used for college or rolled over to a younger sibling.  So let’s take a second look at the often overlooked Coverdell ESA for use as a grades K-12 education fund.

What’s a Coverdell ESA?  An education savings account that can be used to pay for qualified education expenses for K-12 schooling and higher education, e.g. college.

Overview of the features of a Coverdell ESA

  • Works like a Roth IRA, non-deductible (after-tax) contributions, tax-free growth and distributions for qualified educational expenses (see below).
  • A maximum contribution limit of $2000 total per year per child by all contributors, meaning the total contribution a child receives from all sources i.e. parents, grandparents, any relatives, friends, etc. can not exceed $2000 per year no matter how many Coverdell accounts may be open.
  • Income limits where if you have a modified adjusted gross income (MAGI) of $220,000 for joint filers or $110,000 for single filers you can’t contribute to a Coverdell ESA.  (A workaround is to gift the money to your child and open it directly under them.  See below.)
  • All contributions to an ESA must be made before your child turns 18 years old and the funds must be used by age 30 (unless (s)he is a special needs child).
  • Can rollover to sibling or other family member as long as they are under age 30 (no age limit with a special needs beneficiary)
  • Many different investment options comparable to an IRA
  • Not as widely available as a 529 plan.  For example, Vanguard no longer offers an ESA and neither does Fidelity.  Doesn’t seem to able to be opened online, must fill out paper application.

Qualified expenses covered by a Coverdell ESA can be used for private, public or religious schools K-12:

  • Tuition and fees (e.g. private school)
  • Books, supplies and equipment – based on the IRS verbage which states “in connection with enrollment or attendance at an eligible elementary or secondary school” you can count backpacks, pencils, pens, calculators, protractors, etc. to be covered by an ESA.  Yay!
  • Academic tutoring – I know I needed some chemistry tutoring when I was in high school.  Glad to know I can use my Coverdell ESA funds to pay for tutoring expenses for my kids, they’ll probably need it.
  • Special needs services for a special needs child.
  • After-school care – Working parents rejoice! We have another way to get a tax break of some kind.
  • Computers and internet access – How great is this? Though not for computer games or software unless for educational use.
  • Only if required by the school: uniforms, transportation, room & board

What if I make too much to contribute to an ESA?  If you make too much income but really want to open a Coverdell ESA a workaround is to first gift the money to your child and have them make the contribution directly.  This requires some extra work on your part, but I think it’s worth it, especially if you’re sending your kids to private school and/or have a lot of education related expenses.  In order to gift the money you would have to set up a custodial account for your child and transfer the money into the account.  There are possible legal and tax implications with a custodial account that are beyond the scope of this post, but generally for purposes of opening the Coverdell ESA you probably won’t run into them.  The money has to be gifted under you state’s Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA).  So let’s say you want to open a Coverdell ESA for your child, but your household MAGI exceeds the IRS limit.  You would first open a custodial account through a bank or financial institution like Bank of America or Vanguard and put in $2000 or less.  For purposes of opening the Coverdell ESA it’s probably best not to invest the money but rather use a cash fund like a money market fund or just open a custodial savings account at a bank, since investment returns might trigger taxes.  After the custodial account is funded you should be able to open a Coverdell ESA under your child using those funds so its as if they are making the direct contribution and not you the parent.  Remember that funds in both a custodial account and a Coverdell ESA under your child will seriously affect their financial aid.  So my recommendation if you’re opening a Coverdell ESA to pay for K-12 expenses where your child is the direct contributor, would be to use up all the funds by the time they are about to start college.  You should be using a 529 plan or something else for a college savings plan unless you don’t care about financial aid eligibility.

Where can I open a Coverdell ESA?  As mentioned above it’s not as widely available or as easy to open as a 529 plan or Roth IRA.  Savingforcollege.com has a nice little table of different Coverdell ESA providers.  I’d go with TD Ameritrade which has no account fees or minimum contribution or TIAA-CREF if you plan on funding the maximum $2000.  TIAA-CREF generally has a very good reputation as it is the retirement provider for many people who work in academics and research, such as teachers and professors.  Schwab however offers both a custodial account and Coverdell ESA and it might be convenient to open both accounts at one place if you need to do the workaround of gifting the money to your child first before opening the Coverdell ESA.

A few final thoughts on using the Coverdell ESA for K-12 education expenses is to consider starting one as early as possible, since the earlier you open an account the faster you can get the money you contribute invested and growing before you use the funds.  Afterall, without the tax-free investment growth, it’s really just a savings account with no special advantage.  For example, if you open one right when your child is born, you’d have at least 5 years of contributions which is $10,000 (5 x $2000 = $10,000) and the growth on the investment before your child enters kindergarten when you can start using the funds.  Along those lines, unlike using a Coverdell ESA or 529 plan for college savings, depending on when you plan on using the money, you should probably invest more conservatively since the timeline to use the funds is significantly shorter than if you were planning on using the funds for college.  If you plan on using it in kindergarten that only give you 5-6 years from the time you open an account assuming you open one right when your child is born vs. if you plan on using it mostly in middle school or high school which gives you at least 10 years of growth.  Either way I think the Coverdell ESA is another way to shelter some money from the tax man and to pay for expenses you would already have to pay for and so I’m glad I took another look at the Coverdell ESA.

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