Coverdell ESAs are savings plans described in Section 530 of the Internal Revenue Code (IRC). They're accounts that Congress created to allow you to save now for future educational expenses, whether primary, secondary, or postsecondary, of a designated beneficiary.
You can invest money in Coverdell accounts in a variety of ways: stocks, bonds, money market accounts, certificates of deposit, and so on, although you may not invest in life insurance policies. And I really mean that you can invest; under the Coverdell rules (and unlike Section 529 rules), if you designate yourself the one responsible for all decisions on this particular account (also known as the responsible adult, who must be the parent or legal guardian of the minor child), you keep control of the money and make all the investment decisions for your child's account. Over the years, the investments will hopefully earn significant income through interest, dividends, and capital gains, until the time that the account is closed.
You pay no income tax on the income when it's earned, and as distributions are made from these accounts to your designated beneficiary for qualified educational expenses, the income portion of the distribution is not taxed, either to you or to your student.
A Coverdell ESA must be opened as such, in writing, and you need to designate a beneficiary when you create it; you aren't allowed to take an already existing account and decide that it's now the Coverdell account for your student. Money that you contribute into the account is held by a trustee or a custodian, which must be a bank, mutual fund company, or any other entity that's approved by the Internal Revenue Service (IRS).
Understanding Coverdell Changes
When these accounts were first introduced in 1997 as Education IRA's, they were limited to $500 a year aggregate contribution per student, and distributions could be used to cover only postsecondary expenses. If you were thinking of making a contribution into any plan, you probably would've chosen a Section 529 plan, which had fewer restrictions and allowed you to maintain some contact with your money. Basically, the old Education IRA was a nonstarter for most people because contribution limits were fairly pathetic, and much better ways to save money for college were available.
In the new world of Coverdell (same code section, different name), the aggregate contribution limit has been raised to $2,000 per year, the definition of "qualifying student" has been hugely expanded, and you may now contribute to both a Coverdell account and a Section 529 plan for the same beneficiary in the same year. With all these factors, plus an increase in the income phaseout limitations present under Coverdells but not 529 plans, these accounts can become useful savings tools for many families.
Looking At The Major Differences Between Coverdell Accounts and 529 plans
On their faces, Coverdell ESAs and Section 529 plans seem to be two peas in a pod: Both are designed to encourage savings for higher education, and after passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, both now allow tax-free distributions if they're used to pay for qualified educational expenses.
Still, Sections 529 and 530 (governing Coverdell ESAs) of the Internal Revenue Code are quite different, and the savings plans that they govern contain several crucial differences. Among them are the following:
- Coverdell accounts have strict limits on the amount of income any contributor (with the exception of a corporate or charitable one) may earn in a particular year in order to make contributions into the account; Section 529 plans carry no such restriction.
- Coverdell accounts have strict limits on the amount that may be given into any account for a specific designated beneficiary in each year, while Section 529 plans do not (only overall plan maximums). In addition, contributions may not be made after age 18 for the designated beneficiary of a Coverdell account. Section 529 plans have no beneficiary age limit. Accordingly, 529 plans have the capacity to transfer significant amounts of wealth, while Coverdell accounts are much more modest in size.
- Assets inside a Coverdell account are considered to be owned by the designated beneficiary and are therefore counted as the student's asset when calculating financial aid formulas, while asset ownership in a Section 529 plan is much more confusing, depending on how you look at it. For gift and Generation-Skipping Transfer tax purposes, the assets have transferred to your designated beneficiary, while for financial aid purposes, the assets are counted as the account owner's.
- If you live in a state that gives a deduction or credit for Section 529 contributions, no state gives the same benefit for Coverdell ESA contributions. All your contributions will be made "after tax" for both federal and state purposes.
- Qualifying students under Section 530 include everyone from kindergartners through college and graduate school students, and you may pay a wide variety of elementary and secondary educational expenses with distributions from Coverdell accounts (in addition to the qualified educational expenses of eligible postsecondary institutions). Under Section 529, only postsecondary students are qualified, and you may use plan distributions to pay only the qualified educational expenses of eligible postsecondary institutions.
Knowing Who Owns The Account
No matter who makes contributions into a Coverdell ESA, the IRS considers the designated beneficiary to be the owner of the assets. If you structure the accounts for your children correctly, though, you can remain in control of the assets by naming yourself the responsible adult, or the person in control of the account, when you open the account.
If, when your children turn 18, your philosophy is to turn their finances over to them to help them establish their independence, or if you feel your child at that age is more savvy about money and investments than you'll ever be, you may put your child in control at that time, although you don't have to.
If your inclination is to give your child control of his Coverdell ESA account, think carefully before you do. As long as you remain the responsible adult, you make the decisions regarding distribution; your child may have other ideas about what constitutes appropriate use of the money in the account. Even though there are significant penalties for taking nonqualified distributions from a Coverdell ESA, 18-year-olds aren't known for making decisions based on sound financial reasoning; you have to understand that your child may decide to take the money you've saved for his college and run.
Identifying Qualifying Students
In a major departure from the Section 529 definition of "qualifying students," Coverdell qualifying students consist of almost anyone who's studying anything or who's likely to study anything at a later date. This means that, if your budding Picasso is taking up the fine art of finger painting at her local private kindergarten, you may choose to pay for the tuition there by using distributions from your Coverdell ESA. You can do the same at each step along the way, all the way up to and through college and graduate school. There are some caveats, though, that you need to remember.
Age Limitations At Time Of Contribution
In general, you have 18 years in which you, or anyone else, for that matter, can fund a Coverdell ESA for your child, from his date of birth until the day before his 18th birthday. After that, you're done. No matter how much or how little you've managed to put away for that student, you can't add any more to the account. Any increases from now until the termination of the account will have to come from the earnings off your good investments.
Age Limitations At Time Of Distributions
Coverdell ESAs must be completely distributed by the time your designated beneficiary hits his or her 30th birthday. If money is still left in the account on that date, it must be distributed within 30 days, and any earnings on it will be taxed to the beneficiary, plus whacked with a 10 percent penalty.
If you're fast approaching your beneficiary's 30th birthday and substantial money that you may not want to be giving as a birthday gift remains in the account, you can change the designated beneficiary on the account to a member of the current beneficiary's family, provided, however, that the new beneficiary is under age 30.
Saving For Disabled And Special-needs Students
While members of Congress have essentially stated that your children should have completed their educations by their 30th birthday, they do also recognize that some students will spend their lives in special schools. Accordingly, if you're the parent or grandparent of a special-needs student, there are no age limitations either on contributions or distributions on behalf of these students.
Regulations defining who exactly is a special-needs student haven't been released, and no one is sure where the line defining a disability will be drawn. For instance, total deafness may be included, but 50-percent hearing loss could fall outside the boundaries. If you feel that your student's disability or special need may not be severe enough to fit a narrow definition and if you're approaching the ordinary deadline for contributions, you may want to err on the side of caution and stop contributing at age 18 until clearer guidelines are available.
Recognizing Qualified Education Expenses
Qualified education expenses under Code Section 530 are those expenses that you're required to pay (or figure out some other way of meeting) if your student is to enroll at an eligible school. Just as in Section 529, though, many other expenses may be qualified, depending on the requirements of the school and of the particular program your student may be enrolled in.
First, you need to know what constitutes an "eligible school." For the purposes of IRC Section 530 and Coverdell ESAs, eligible schools include all public, private, or religious schools that provide either primary or secondary education as determined under their applicable state laws. All postsecondary educational institutions that are qualified under Section 529 also qualify as eligible schools under Section 530.
The addition of primary and secondary schools to the list of eligible institutions is quite a bonus, as it assigns tax-exempt status to earnings used to pay for primary and secondary school expenses (this is the one and only place in the entire Internal Revenue Code where this happens). This provision is a part of the Economic Growth and Tax Relief Reconciliation Act of 2001 that changed the Education IRA to Coverdell. This legislation expires on December 31, 2010. If it isn't extended or made permanent by that date, the law sunsets back to its pre-2002 conditions, in which only postsecondary educational institutions will be qualified.
Qualified Expenses For Elementary And Secondary Education
In addition to tuition and mandatory fees, other elementary and secondary education expenses may be eligible for payment using Coverdell distributions. Some expenses may seem obvious; others may surprise you:
- Books, supplies, and equipment related to enrollment: In these days of shrinking school budgets, parents need to supply their children with more and more of what used to be considered necessary school supplies. Amounts that you spend for pens and pencils, notebooks, erasers, and the like are included here. You may also use a distribution from your Coverdell to pay for textbooks and any other required reading material that's not supplied by the school district.
- Academic tutoring related to enrollment: The math or science tutor (or even a dance instructor if your child is a dancer attending a school for the performing arts) is covered here, but your child's extracurricular piano or dance lessons are not.
- Special-needs services for students with special needs or disabilities: If your student needs a one-on-one aide with him and the school doesn't cover the expense, this service qualifies, as does special equipment necessary to accommodate him. However, when assessing what qualifies here, remember that the regulations regarding special needs haven't been issued yet.
- Room and board, but only if a requirement of attending that particular school: Clearly, if you send your child to a boarding school 300 miles from your home, room and board would be required; if, however, you live in the next town, this expense may be questionable.
- Uniforms, when required by the school: The cost of voluntary school uniform programs doesn't constitute a qualified educational expense, nor does the annual cost of buying your child school clothes.
- Transportation, when required by the school: The expense of driving your student to and from school every day doesn't qualify, but the price you're charged for the mandatory school bus does. As more and more communities begin to charge families for the cost of transportation to and from school, this expense will become an item that more people may choose to pay from their Coverdell accounts.
- Supplementary items and services, including extended day programs: If your child attends an after-school program or an extended day program at his or her school, you may choose to pay these costs from your Coverdell account. The payment must be made to the school, however, so once again, those extracurricular piano lessons probably aren't covered here.
- Computers, printers, other peripherals, Internet access, software, and so on: To the extent that you can document that the use of this equipment and programming is to benefit your student's education, even if you may be the primary user of this equipment, you may pay for it by using a qualified Coverdell distribution. Items that aren't used for educational purposes, though, don't count as qualified expenses, so the video games, the joystick you buy for your computer, and any gaming, sports, or hobby software don't qualify.
Qualified Expenses For Higher Education
When your student reaches the halls of higher learning (or any other school after he's completed high school), the rules regarding what constitutes a qualified expense for the purposes of Coverdell distributions change. The higher education rules fall in line with those for Section 529 plans, which makes sense. The 2001 tax law changes focused on adding primary and secondary education; it pretty much left alone what was already in place regarding postsecondary education.
In general, the following lists constitutes qualifying educational expenses for postsecondary education payable by tax-free distributions from Coverdell accounts:
- Tuition and mandatory fees at eligible educational institutions: For a school to qualify, it needs to be able to participate (but doesn't have to if it chooses not to) in federal financial aid programs administered by the Department of Education.
- Required books, supplies, and equipment: The books on the lengthy list that every professor hands out on the first day of class, laboratory equipment, and any required computer equipment (including peripherals) qualify. Your child's cell phone, which you may require for your peace of mind, does not.
- Room and board expenses: These expenses are qualified only if
- They're paid directly to the school itself and your student is attending class at least half time or
- They don't exceed the amount the school budgets for these expenses, provided your designated beneficiary is at least a half-time student.
If the room and board fees that you pay directly to the school exceed the amount the school budgets for this expense, that's okay. You can still pay the full amount by using a qualified distribution from a Coverdell plan. It's only for that off-campus housing (including fraternities and sororities) that you need to be careful.
Many qualified expenses for elementary or secondary school aren't qualified after your student graduates from high school. When you send your student off to college, don't try to pay for that new computer and peripherals from your Coverdell ESA unless the school requires it as a part of the course. You also won't be able to pay for any after-school programming, transportation, uniforms, or academic tutoring for your postsecondary beneficiary with Coverdell funds unless you also want your student to pay income tax and a penalty on the income portion of the distribution.
Following Investing Rules And Regulations
Coverdell ESAs generally follow the same investment rules and regulations as both traditional and Roth IRA accounts. Unlike 529 plans, there's an awful lot that's allowed, and not much that's prohibited. Still, to keep everything kosher, you need to know what you can't do and ways you can't invest.
- Your contributions need to be made in cash or cash equivalent.
- You may not purchase collectibles or life insurance with the money in your Coverdell ESA. You're prohibited from buying insurance policies, artwork, household furnishings, antiques, metals, gems, stamps, or certain coins with that money, no matter how fine an investment it may appear to you. Specially minted U.S. gold and silver bullion coins and certain state-issued coins may be permitted. In addition, platinum coins and certain gold, silver, platinum, or palladium bullion are also allowed. If you're interested in making this sort of investment with Coverdell funds, check Internal Revenue Code Section. 408(m)(3) to make sure that the coins or bullion you have in mind qualify.
- You may not commingle Coverdell account funds with any other funds. Your Coverdell account needs to be set up and accounted for completely separately from any of your other assets. The custodian or trustee, however, has the ability to commingle the money in your Coverdell account with money in other Coverdell accounts, creating what's known as a "Common Trust Fund" or a "Common Investment Fund." These funds work to your advantage because they allow the custodian or trustee to buy investments in larger pieces (which is less costly overall) and then split the pieces among all the accounts that contributed to the purchase.
- You may not pledge the value of a Coverdell ESA as collateral for any sort of loan. Not only are loans to you and your designated beneficiary prohibited, but so too are margin accounts, or brokerage accounts that allow you to borrow against the value of your stocks in order to either buy more stocks or take cash out of the account.
- You may not take a loan from a Coverdell ESA, nor may your designated beneficiary. The money that's in the account stays in the account until it's time to make distributions to your beneficiary. Any money that comes out may only come out as a distribution. After it's removed from the account, it may not be returned or repaid later.
- You may not pay yourself or anyone else for managing your student's Coverdell ESA by using funds from the account. The only fees that may be charged against the account are the custodian's or trustee's. If you need to hire an investment advisor to help you select investments, you need to pay his fee out of your funds, not the account's.
- You may not sell or lease your property or your beneficiary's property to a Coverdell account, nor may you make any other sort of asset exchange. The only thing that goes into the account is cash, and the only thing that should ever come out is cash, in the form of distributions to your beneficiary. Any other transaction is prohibited.
The custodian or trustee you choose to manage your Coverdell ESA may have other prohibitions in place. You may not be allowed to invest in real estate, for example, or trade in anything more complicated than ordinary stocks and bonds (as opposed to options, puts, calls, or the like). The custodian may also limit you to a certain group of mutual funds or their own certificates of deposit. Investigate what limitations the custodian has in place before you open your account, and make sure that you can live within those rules.
If you goof and make a prohibited transaction under Section 530, you and your beneficiary are out of luck. The entire account will lose its tax exemption or deferral on the day of the prohibited transaction, and your designated beneficiary will be required to report 100 percent of the built -up earnings in the account from inception on his tax return for that year.
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