Coverdell ESA: The Underutilized and Underappreciated College Savings Account

The Coverdell ESA is probably the least understood and most underutilized of all the college savings accounts. I almost never come across anyone who has one, and I’m not sure I’ve ever had a client even ask me about the possibility of opening a Coverdell ESA.

But in the right situations a Coverdell ESA is a helpful tool. It offers many of the same tax benefits as a 529 plan, with some additional flexibility to use the money tax-free in a wider variety of situations.

There are some limitations as well, and some good reasons why it’s not as widely used as 529 plans and other college savings accounts.

In this post you’ll learn all about those benefits and limitations, and specifically how they compare to 529 plans, so that you can decide for yourself whether a Coverdell ESA should be a part of your college savings plan.

IMPORTANT UPDATE: The tax bill passed in December 2017 newly allows up to $10,000 per year, per child to be withdrawn from 529 plans tax-free and penalty-free for K-12 education educations (see here). While this doesn’t completely eliminate the purpose of Coverdell ESAs, it does significantly limit their usefulness. The rest of this post will be updated soon in order to reflect this change, but keep in mind that there are now far fewer situations in which using a Coverdell ESA makes sense. Click here to learn more about which college savings account you should choose instead.

The benefits of a Coverdell ESA

Let’s start with some of the reasons why you should consider a Coverdell ESA.

First, a Coverdell ESA offers many of the same tax breaks that make a 529 plan such a great place to put your college savings:

• Contributions are non-deductible (there is some difference here compared to a 529 plan, which I’ll get into below)
• The money grows tax-free while inside the account
• The money can be withdrawn tax-free for qualified education expenses

Second, the big advantage of a Coverdell ESA over the more popular 529 plan is that the money isn’t locked away until college. You can certainly use it as a college savings tool, but you can also use the money tax-free to pay for certain K-12 expenses.

This can be a huge help for parents who want to send their kids to private school, or who simply want to hire a tutor or need some help paying for books and other supplies.

And if your child has special academic needs, the money within your Coverdell ESA can be used for those as well. This guide from the IRS has all the details on which expenses qualify for tax-free withdrawals.

Third, just like a 529 plan, you can change the beneficiary at any time. Which means that if one child doesn’t end up needing the money, you can always use it for another child.

So in a lot of ways, a Coverdell ESA is a more flexible version of a 529 plan. It has many of the same tax breaks and gives you more options for using the money.

The downsides of a Coverdell ESA

Of course, the Coverdell ESA comes with some limitations, especially when compared to a 529 plan.

First, while some states allow you to deduct contributions to a 529 plan for state income tax purposes, there’s no such benefit for a Coverdell ESA. If you live one of those states, that deduction may be enough of a reason to choose a 529 plan over a Coverdell ESA.

Second, contributions to a Coverdell ESA are currently limited to $2,000 per year, per child. That’s across all donors too, so if Grandma and Grandpa put $1,000 into a Coverdell ESA for your daughter, you’re only allowed to contribute another $1,000.

That’s in contrast to a 529 plan where a married couple can typically contribute up to $28,000 per year, per child, without any tax consequences. And that’s on top of any amounts that other family and friends decide to contribute.

Third, while there is no income limit for 529 plan contributions, Coverdell ESA contributions are not allowed once your income reaches a certain point.

For married couples filing jointly, your allowed contribution begins to decrease once your Modified Adjusted Gross Income reaches $190,000, and it’s eliminated completely once you reach $220,000. For single filers, the range is $95,000-$110,000.

Fourth, like a 529 plan, any earnings you withdraw that aren’t used for qualified education purposes will generally be subject to taxes and a 10% penalty.

Finally, unlike a 529 plan, the money you contribute is solely meant to be used for the benefit of the named beneficiary. So, let’s say you have $10,000 in your account that you don’t end up needing for your child’s education. With a 529 plan, you could withdraw the money, pay the 10% penalty, and use it for anything you want. With a Coverdell ESA, you could withdraw the money, pay the 10% penalty, and use it for any purpose that benefits the person named as beneficiary on the account.

In this sense, a Coverdell ESA is slightly less flexible than a 529 plan, though you are allowed to change the beneficiary as a partial workaround. You can read more about this provision here.

To sum it up, the biggest downsides to a Coverdell ESA, when compared to a 529 plan, are the restrictions on contributions. And if you live in a state that allows you to deduct 529 plan contributions for state income tax purposes, that would further tilt the scales away towards a 529 plan over a Coverdell ESA.

How can you open a Coverdell ESA?

One of the tricky parts of utilizing a Coverdell ESA is that it’s not always easy to find a good investment company to open one with. Vanguard, my favorite investment company, no longer offers them, and many of the other major providers of IRAs and other investment accounts don’t offer them either.

This list of Coverdell ESA providers is a good place to start, and in general I would look for the following characteristics:

• No or low account minimum (assuming you are starting with a small initial contribution)
• No account maintenance fees
• Access to low-cost index funds
• Minimal trading fees, and ideally access to a set of mutual funds and/or ETFs you can buy and sell without any trading fees

If you’d like some guidance on how to invest the money within your Coverdell ESA, this post should help: How to Beat 80% of Investors With 1% of the Effort.

Should you contribute to a Coverdell ESA?

With all that, when does it make sense to contribute to a Coverdell ESA?

While every situation is different, I’d say that it’s generally worth considering for people who meet the following conditions:

• Either specifically want to save for K-12 expenses or want to have the option of using the money for K-12 expenses
• Don’t live in a state that offers a state income tax deduction for 529 plan contributions
• Fall under the income limits for Coverdell ESA contributions

It’s also worth noting that this doesn’t have to be an either/or proposition. You’re certainly allowed to contribute to both a Coverdell ESA and a 529 plan, and even to add another college savings account in there as well.

In fact, one strategy to consider is making your first $2,000 contribution each year to a Coverdell ESA and any additional contributions to a 529 plan. That would give you the best of both worlds and some additional flexibility to use the money whenever it’s needed.

The one thing to keep in mind here is staying within the annual gift tax exclusion. For 2017, you’re allowed to gift up to $14,000 to someone else without gift tax purposes. Married couples are allowed to combine their limits, giving them the opportunity to gift a total of $28,000 to each child without tax consequences. (The limit is going up to $15,000 in 2018, so the combined limit for married couples will be $30,000 per child.)

That’s a combined limit across all gifts, and contributions to a dedicated college savings account like a Coverdell ESA or 529 plan count as gifts. So as long as you stay within those limits, you shouldn’t have anything to worry about.

Coverdell ESAs: underutilized and underappreciated

When it comes down to it, Coverdell ESAs probably aren’t utilized as much as they should be.

While there are some limitations, and while they certainly aren’t the right choice for everyone, in the right situations they offer almost all of the same benefits as a 529 plan with increased flexibility to use the money tax-free for K-12 expenses.

So, how about you? Have you ever used a Coverdell ESA? Or do you think you’ll start using one now that you know a little more about it?