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Saving for College: Coverdell Education Savings Accounts

Key Points
  • You can use a Coverdell Education Savings Account (ESA) to fund elementary and high-school expenses as well as college, and you'll have more investment options than a 529 plan gives you.

  • The drawbacks: These accounts are subject to an income eligibility limit, and you can contribute only $2,000 a year per beneficiary.

  • Here, we'll cover the basics of ESAs, including how they impact financial-aid awards.

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 investment income or capital gains.

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

The table below shows how Coverdell Education Savings Accounts compare with 529 plans.

 

ESA

529 plan

Tax-free withdrawals

Qualified expenses for kindergarten through college

Qualified expenses for college only

Investment options

Many

Limited

Income eligibility limit for contributors

Modified adjusted gross income less than $220,000 for joint filers. Annual contributions are capped at $2,000 for MAGI up to $190,000 and are gradually reduced for MAGI between $190,000 and $220,000. Incomes above $220,000 are ineligible.

None

 

(Gift taxes may apply above $14,000/year)

*Annual contributions for single filers are capped at $2,000 for MAGI up to $95,000 and are phased out for MAGI between $95,000 and $110,000.
 

ESAs give you more investment flexibility, and you can use the withdrawals tax-free for education expenses from kindergarten all the way through college. However, there's an income eligibility limit and a relatively low limit on contributions, unlike 529 plans. The annual maximum is just $2,000 per beneficiary—or less for higher earners—which means if you contribute all $2,000, grandparents and other individuals may not make additional contributions to the account that year.

The good news is your child can be the beneficiary of both a 529 plan and an ESA, and you can contribute money to both accounts in the same year. So if you’re eligible for an ESA, you can contribute the first $2,000 there to keep the funds available for K-12 expenses. If you can contribute more than that, consider putting the excess into a 529 plan for college.

What if you don't need the money for education after all?

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, any untaxed earnings are 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:

  • No more than $2,000 per year can be put in a child's ESA(s). The beneficiary must be under age 18 in the year of contribution (unless he or she is a special needs child).
  • The $2,000 maximum is dependent on your filing status and modified adjusted gross income (MAGI). For joint filers:  Contributors with an MAGI of less than $190,000 ($95,000 for single filers) can contribute up to the full amount. Contribution limits are lower at higher MAGIs, and are completely phased out for contributors with an MAGI of $220,000or more. (See table above.)
  • 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.
  • You have until April 15 of the following year to contribute for the previous year.

Use your ESA to invest for growth

Although past performance is no guarantee of future returns, stocks have historically 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 in a diversified portfolio that includes stocks. Then, gradually move those funds to more conservative holdings as your child nears college age.

If you plan on using your ESA for K-12 expenses, then you might consider a more conservative allocation to account for the shorter timeframe. 

If you do 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.

Effect on financial aid

ESAs generally receive favorable treatment when it comes to calculating financial aid eligibility, similar to a 529 plan. (With a 529 held in a parent's name, typically only 5.6% of the assets are considered available for college expenses.) However, schools can use slightly different formulas to calculate financial aid eligibility, which could mean even ESA accounts held under a grandparent or non-relative's name might have to be reported. This will depend on the school.

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. Every dollar saved is one dollar you may not have to borrow.

For more about financial aid, check out U.S. Dept. of Education or the College Board.

1Although 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.

Next Steps

Important Disclosures

Before investing, carefully consider the plan's investment objectives, risks, charges and expenses. This information and more about the plan can be found in the disclosure statement or Participation Agreement available from your financial institution and should be read carefully before investing.

As with any investment, it's possible to lose money by investing in a 529 or other educational savings plan. Additionally, by investing in a 529 plan outside of your state, you may lose tax benefits offered by your own state's plan. State tax treatment of earnings may vary. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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