I recently went ahead and opened a Coverdell ESA for one of my kids through USAA and came to realize there are several pitfalls to the Coverdell ESA that I’ve run into, so I decided I should write a follow-up to my post about Coverdell ESA’s for use during kindergarten to 12th grade going over some of these potential pitfalls. Bear with me as I veer off on a tangent that is completely related to why I opened one.
Kindergarten problems: My daughter is approaching kindergarten age, but unfortunately (in our opinion), she’s born after the September 1st cutoff date for entering kindergarten. She falls into the transitional kindergarten (TK) birthday range which is September 2 – December 31st. If we follow the state cutoff, not only will she have to waste an academic year in TK (again our opinion), she’ll be the oldest in her class for the rest of her education life and while some parents might like that I’m not sure that’s what’s best for my daughter. We feel she’s more than ready academically and that she’s socially and emotionally ready too. Another issue at play here is that the schools we’re going to be sending our kids to only offer half-day kindergarten (as in 3-4 hours) and they’re split in two groups, the early start group (start time around 8am) and the late start group (start time around 10am). I was shocked. As a working parent I find this incredibly inconvenient, especially if we were to get the late start. Of course schools offer AM and PM childcare but I doubt these after school programs offer any real academic structure and it’s not like they are free either. Therefore it seemed better to invest more money into sending our daughter to one year of private kindergarten, where she can presumably receive more rigorous academic teaching, all day childcare and where the cutoff date is more flexible as private schools do not have to adhere to California kindergarten cutoff date. This way she will be able to transition into first grade the following year.
Looking into the prices of private kindergarten I saw there is a wide range, ranging from $7000/year (for the school year) all the way up to $37,000/year. Yikes! I was expecting $20,000/year (including after-school care and summer) so seeing $7000/year was encouraging, though that price tag does not include after school care or summer care. Anyways, coming back around, I realized I better hurry up and open a Coverdell ESA to help cover some of these costs!
Unfortunately, as soon as I opened one up, I ran into some pitfalls that made me realize the Coverdell ESA wasn’t going to be all that helpful for covering private kindergarten costs or much of elementary school costs either for us. Hopefully hearing about my situation will help you better determine if a Coverdell ESA is worth opening and avoid some of these pitfalls. For more details about what a Coverdell ESA is and how it works, read my previous post here.
- Contribution limitation of $2000/year per beneficiary. At first I didn’t think this was that big of a deal, but when I tried to invest the funds in my daughter’s ESA into one of my favorite low-cost Vanguard index funds, I realized the vast majority of Vanguard’s funds require a $3000 minimum. Bummer! So that means for at least 1 year I’d have to invest in higher costs funds or individual stocks/bonds before I could potentially reach the $3000 or often higher minimums of Vanguard index funds.
- Limited investment options with initial funds. So then I started browsing the funds available to invest for $2000 or less and I saw there wasn’t much at all. Even USAA mutual funds require $500 + $50/month minimum investment or at least $1000 and these mutual funds aren’t cheap. Considering I’m used to Vanguard index funds which charge an expense ratio ranging from as low as 0.05% to maybe 0.6%, I was aghast to see expense ratios of 1.2% and not even sure they have a loading fee.
- Income limit capping out at Modified Adjusted Gross Income (MAGI) of $110,000 (single) or $220,000 (married filing jointly) for 2016. Actually in order to be able to contribute the full $2000 to a Coverdell ESA your MAGI cannot exceed $95,000 (single filer) or $190,000 (married filing jointly) for 2016. So from $95,001 to $110,000 or $190,001 to $220,000, you can only contribute a prorated amount to a Coverdell ESA. For example, if for 2016 you filed married filing jointly and your MAGI was $200,000, you can only contribute a prorated amount of $1,333.33 to a Coverdell ESA per beneficiary for 2016, not up to $2000. See below for another example from the IRS website.
If you exceed the maximum contribution limit, you’ll have to pay a 6% excise tax on the excess contributions. The less you are allowed to contribute, the more limited you are in your investment options at least when it comes to index funds and mutual funds. You pretty much have to construct a portfolio of individual stocks and bonds and if you’re into that kind of thing that’s great, but as for me, that’s really not my cup of tea and that means I’d most likely have to outsource this to a pro, incurring even more costs and fees eating away at my already small investment. I’m not sure what our MAGI will be for 2016, but I really miscalculated. Due to sudden and potential employment changes for both my husband and myself we’re probably going to exceed the income limit. If we don’t completely phase out, we’ll only be able to contribute a prorated amount and it’s highly likely that going forward, we won’t be able to contribute again for the near future. So don’t make my mistake — make sure you take a look at your MAGI on your tax return and consider your future income(s) before opening one up. If you’re near the cutoff, it might not be worth it since you can only contribute a prorated amount and because you might actually completely phase out as well. There is a work around to the income limit, which is to gift the money to your child and open a custodial account and then have them fund the Coverdell ESA directly so that they are the owner and not simply a beneficiary. It’s definitely a bit more complicated and don’t forget that it would count heavily against their financial aid, but if you use up most or all of the funds before college then the financial aid impact shouldn’t be much of an issue. Another option could be to have the grandparents (or other extended family) open it.
- Short investment timeline. My first child is already almost 4 years old and unfortunately I only recently opened one up. By the time I need to tap into the Coverdell ESA, I’ll only have at most 1.5 years of growth. Even if I opened one right when she was born, that would only give me 5 years before needing it for kindergarten. Therefore I feel it’s use is pretty limited for covering elementary school costs. That’s hardly any time to allow my investments to grow significantly and a good chance that it might even be below my initial contribution when I need to access it! The rule of thumb that most financial advisors recommend is that if you need the money in less than 5 years, it’s better to keep it liquid. A good place might be a high yield online savings account, money market account or even a CD, but probably not invested in the stock market. Since you don’t get any tax break for opening a Coverdell ESA, if you don’t plan on taking advantage of the tax-free growth and distribution, there’s really little point to opening one up.
- Limited options for places to open a Coverdell ESA. I really believe in simplicity for my finances and therefore strongly prefer to keep most of my investments in one place, i.e. Vanguard. Unfortunately, Vanguard no longer offers the Coverdell ESA and neither does a lot of other financial institutions. Huge con for me. Additionally, most places require a PAPER form to open one up. Schwab, TIAA-CREF and TD Ameritrade, you can’t open one online. USAA actually did allow me to open a Coverdell ESA account online so that was nice, but they have very limited investment options. Schwab on the other hand is probably the best place to open a Coverdell ESA if you plan on trading individual stocks.
Bottom line is that I realized opening a Coverdell ESA can be worth it since every little bit with education costs help, but you really need to plan ahead.
- Start one as soon as your child is born to give you the maximum time to invest. It’s probably not a good idea to use the funds for K-5, but would be a good option for grades 6-12.
- Consider your current income(s) and future income(s) and if you’re near the MAGI cutoff keep in mind that you may only be able to make a few or limited contributions and it might not be worth it to open one.
- If you are planning on using the Coverdell ESA to pay for private school tuition, it’s probably not going to make much of a dent. Additionally, I’m guessing if you can afford to send your kids to private school, you probably exceed the income limit.
- If you like investing in low-cost broad index funds through Vanguard or Fidelity, Coverdell ESA is severely limited. If you like constructing a portfolio of individual stocks and bonds, then you might like a Coverdell ESA.
Anyone who has a Coverdell ESA want to share their opinions on it? Is it worth opening one up if you planning on using it for K-12 education costs? Share with us in the comments below!