The Coverdell Education Savings Account

We continue our look at saving money for education, with an examination of the Coverdell education savings account. Once known as an education IRA, these accounts have crucial differences from a 529 Plan. They work like this:

1. Annual contributions are capped at $2,000 per beneficiary. They can come from any source but if the total exceeds $2,000, the IRS will slap a 6% tax on the excess.

2. Contributions are not tax-deductible. But any growth in the investment is tax-deferred, and money can be pulled out tax-free as long as it is used for qualified education expenses, which include items such as books, tuition, room and board and necessary equipment, such as a laptop computer.

3. Money can be withdrawn to cover approved expenses for kindergarten through 12th grade, as well as higher-education expenses. Approved expenses could include private-school tuition or an after-school tutor.

4. The money has to be used before the beneficiary turns 30. If the beneficiary reaches 30, or if the money is used for anything but education expenses, the IRS will levy a 10% penalty plus regular income taxes on the amount pulled out. One major exception: Special-needs beneficiaries can continue to draw from their accounts, tax-free, to cover approved expenses after the cutoff age. Contributions can also be made for a special-needs beneficiary after he or she turns 18.

Why use a Coverdell instead of a 529 Plan?

* Flexibility: Coverdell money can be spent on expenses for kindergarten through 12th grade; 529s are limited to higher-education expenses only.

* Wider investment choice: Coverdells must be held by a bank, a brokerage or some other institution approved by Federal law to handle them. Depending on the trustee chosen, investment choices in a Coverdell can be very broad, including stocks, bonds, mutual funds and nearly any other type of investment vehicle offered by the trustee. Most 529 plans limit their investors to only those options provided by their plans. Those choices are often as narrow as the limited selection of mutual funds offered by only one company. In a handful of states, 529 investors can opt instead for prepaid tuition plans.

What are the disadvantages of a Coverdell?

* Income limits: Coverdell contributions are limited for single taxpayers with adjusted gross incomes higher than $95,000 and for joint filers who bring in more than $190,000. They phase out altogether for single filers with adjusted gross income over $110,000 and for joint filers with AGIs over $220,000. Contributors to 529s face no income limits.
* Contribution size: Coverdells come with a strict $2,000 per beneficiary contribution cap. Some 529 plans will allow contributions as large as $300,000. Under some circumstances, you can contribute up to $65,000 in a single year without incurring a federal gift tax.
* Age cap: Unlike Coverdells, 529 plans allow contributions to accounts for beneficiaries over age 18 and do not require withdrawal at age 30.


Have a look at IRS Publication 970 for more details. And, as always, see your tax professional or trusted financial advisor for more advice specific to your situation.