Raising a child is a big responsibility! While those first few years are devoted to the basics of food, shelter, clothing, and a good night’s sleep, many parents worry about the costs of education. College is a big ticket item, while in many families a private or religious K-12 tuition is also a big expense.
While there are many options to save for education expenses, the Coverdell Educational Savings Account (ESA) is a great tax-advantaged option. Let’s look at the ESA and how it can be a part of your family’s financial plan for educational expenses.
How to Start an Educational Savings Account
You can open an ESA at almost any bank, credit union, mutual fund company or investment company. Do your research on the company, fees, and investment choices – just like you would any type of investment account.
There are companies that require no opening deposit or a minimum deposit and have low annual fees of $10 or less.
Who Can Have an ESA
The beneficiary of an ESA must be a child under the age of 18 or a special needs beneficiary.
The balance of the ESA is not considered the child’s money for financial aid contributions. The custodian of the ESA can change the beneficiary of the account to another family member of the original beneficiary without penalties.
Rules for Putting Money in an ESA
Each beneficiary under the age of 18 can only receive $2,000 per year in contributions, regardless of the number of accounts that are opened in their name or how many people are putting money in the account.
You do not need to be related to a child to open or contribute to an ESA account. An organization or trust is allowed to contribute to an ESA without any income restrictions.
Parents need to coordinate with other contributors to their child’s ESA account. Otherwise, there will be a 6% excise tax on the contributions over $2,000 per year and on the related earnings each year that the excess contribution remains in the account.
Contributions are still taxed, but any growth in the account is tax-free. Contributions can be made until the contributor’s tax due date without extentions.
These rules are a little tricky. Not every person can contribute to an ESA. Household MAGI (modified adjusted gross income) cannot exceed $110,000 for single filers and $220,000 for married filers.
Even though a parent might not be eligible to contribute money to an ESA for their child, an aunt or grandparent’s income may be below the MAGI rules so they are eligible to contribute. Separate ESAs are not required for each person who deposits money – everyone’s contribution can go into one ESA as long as the total contributions do not exceed $2,000.
Rules for Taking Money Out of an ESA
Money distributed from an ESA for qualified programs and expenses is withdrawn tax-free. This is a primary benefit of an ESA – tax-free growth.
Qualified K-12 program expenses can be paid from an ESA along with qualified college expenses. Elementary and high schools can be public, private, or religious schools as determined under state law. Colleges must fall within the same guidelines as those eligible for student aid programs from the Department of Education.
ESA money can be used for tuition, fees, required books, supplies, and equipment. Room and board expenses are allowed if the student is at least half-time and the total does not exceed the cost of the school’s dorm and meal plan if they live off campus.
The Hope and lifetime learning credits can be claimed for any expenses beyond what was withdrawn from the ESA for that year if you meet the criteria for those credits. No double-dipping allowed – a specific expense can’t fall under both areas.
The amount of an ESA withdrawal that exceeds qualified expenses will be taxable income to the beneficiary and will also be assessed a 10% penalty. Exceptions to the penalty rules include the death or disability of the beneficiary or receipt of a qualified scholarship.
Once the beneficiary reaches the age of 30, the entire balance of the ESA must be withdrawn within 30 days. The portion of the balance that represents the tax-free growth is considered taxable income for that year and will also have a 10% penalty. This can be avoided if the full balance of the account is rolled over to an ESA for another family member.
How an ESA is Different from a 529 Plan
The money in an ESA account can be used for most K-12 educational programs while the 529 plan is only designed for post-high school education expenses.
ESA contributions are limited to $2,000 per year while a 529 has no annual contribution limits. The 529 plan does have a lifetime contribution limit between $200,000-$300,000.
ESAs have a wider range of investment options and places where you can open an ESA. 529 plans are administered by individual states and have limited investment options.
There are no age restrictions on a 529 plan. Contributions can be made for the benefit of anyone, not just a child under the age of 18. You can even contribute to your own plan. The 529 plans do not require that money be distributed by the beneficiary’s 30th birthday.
The ESA does not allow someone with a higher MAGI to contribute to the account. 529 plans do not have income restrictions for contributors.
There are many different ways to pay for a child’s education. The Educational Savings Account is one option to save and help with those future expenses.
Do you have college savings for your children? Do you have an ESA? What other ways are you planning to help with college expenses?