Saving for College: Coverdell Education Savings Accounts
March 29, 2013
Rande SpiegelmanCPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
Key Points
- An Education Savings Account (ESA) is a great way to invest money to help pay for your child's college education.
- We'll cover the basics of ESAs, including contribution limits and how they impact financial-aid awards.
- Helpful information for anyone interested in saving for a child's education.
A Coverdell Education Savings Account—also known as an ESA—is a special account designed to help pay for your child's education. You set up the ESA and choose how to invest the money, typically on behalf of the child beneficiary.
When you invest in an ESA, potential earnings grow tax-deferred, which means your money has a chance to compound faster because you don't have to pay taxes on current investment income or capital gains.
Use Your ESA to Invest for Growth
Although past performance is no guarantee of future returns, stocks have offered the best chance for money to grow over the long term—though stocks increase your chance for loss of principal compared to bonds or cash. If college is more than 10 years away for your child, consider investing primarily in stocks, either directly or via stock mutual funds and/or exchange-traded funds. Then, gradually move those funds to more conservative holdings as your child nears college age.
If you invest in mutual funds, consider investing in no-load funds to minimize your fees and expenses—these can have a large impact on your return on investment.
Even better, withdrawals are free from federal taxes so long as you use the money to pay for qualified education expenses, which typically include tuition, books, supplies, uniforms, room and board, computer equipment and internet service.
Tax-free withdrawals apply not only to college expenses, but to elementary and secondary education expenses as well, no matter whether the schools are public or private, secular or religious.1
What if your child's plans change? Or, your child graduates and there's money left over in your ESA? You can change the beneficiary on the account to another member of the original beneficiary’s family. Don't worry about finding a family member who needs money for college; the IRS broadly defines the term "family member" to include everyone from siblings and parents to step-siblings and in-laws. Also, remember that the beneficiary has until age 30 to use the money.
If you withdraw funds for non-qualified expenses, the amount is taxable to the beneficiary, along with a 10% federal penalty.
How to open and contribute to an ESA
Anyone can set up an ESA at a brokerage or other financial institution or directly with a mutual fund company. Once an ESA is opened in your child's name, anyone can contribute as long as they follow a few rules:
- Collectively (if more that one account/contributor), no more than $2,000 per year can be put in a child's ESA(s) under current law.
- The beneficiary must be under age 18 in the year of contribution (unless he or she is a special needs child).
- The money must be used (or transferred to another beneficiary) before the child turns 30.
- You can change the beneficiary to another family member once per year.
- The contributor's 2012 adjusted gross income can be no more than $110,000 for single filers or $220,000 for joint filers.
- You have until April 15 of the following year to contribute for the previous year.
ESAs and 529s: Working Together
Your child can be the beneficiary of a 529 plan and an ESA, and you can contribute money to both accounts in the same year.
Effect on financial aid
The US Department of Education has indicated that ESAs should be treated as an asset of the parents. That means ESAs should only have a minimal impact on financial aid, as is the case with 529 plans.
Saving and investing for college is a smart financial move, even if you believe your child may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid.
For more about financial aid, check out FinAid.org or the College Board.
Important Disclosures
1. Although virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions are eligible, there are criteria set by state law and the Department of Education that must be met by the institutions.
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