Q: Tax Playa, I want to open a savings account for my friend's child back home. I'd like the money to go for primary, secondary, and college education. What would you recommend?
Sandy, Arlington VA
A: What you want is a Coverdell Education Savings Account (Coverdell ESA). These accounts act much like Roth IRAs--after-tax money goes in, the money grows tax-free, and distributions are tax-free if used for education. Best of all, Coverdell ESAs can be used for any level of education, not just college...
For more information on Coverdell ESAs, please consult IRS Publication 970, Tax Benefits for Education.
A Coverdell ESA can be established for any beneficiary under the age of 18. Opening a Coverdell ESA is done under very similar rules to opening an IRA, so you would generally do so at a bank or brokerage firm.
For any single beneficiary, total aggregate contributions in a calendar year to all Coverdell ESAs in his name cannot exceed $2000.
Eligibility to contribute to a Coverdell ESA phases out between $190,000-$220,000 of AGI ($95,000-$110,000 for anyone not married filing jointly).
There are two categories of qualified educational expenses that Coverdell ESA funds can be used for:
- Qualified higher education expenses: tuition, fees, books, supplies, equipment, special needs, and room and board for more than half-time students.
- Qualified elementary/secondary expenses: tuition, fees, books, supplies, equipment, tutoring, special needs, computer equipment and Internet access, and (if required or provided by the school) room and board, uniforms, transportation, supplementary items and services (like day care).
As you can see, the options for using the account are quite broad.
Coverdell ESA accounts can be rolled over tax-free. The beneficiary can also be changed at any time if the new beneficiary is under age 30.
The Coverdell ESA beneficiary can take a distribution at any time. If the distribution is not for a qualified educational expense, any earnings on the account face taxes and a 10% penalty. If the designated beneficiary reaches age 30 or dies, the account is immediately-distributed.
Obviously, no double benefits are allowed in coordination with any other tax-advantaged education strategies (deductions, credits, other accounts, etc.)
The choice of which education benefit to take can be a daunting one. 529 plans have almost no contribution limits, but are restricted to college only. Deductions and credits phase out with income.
As a general rule, Coverdell ESAs are a good place for the first $2000 per year in savings for a child's education. Since the money can be used for both college and pre-college expenses (as well as a broader array of expenses), the benefit is more immediate. The only drawback is the access that the Coverdell ESA beneficiary has to the money. An irresponsible child may want to get their hands on it and have a non-qualified withdrawal.
Setting up a Coverdell ESA (and/or a 529 plan, for that matter) is a good idea almost immediately upon the birth of a child. Relatives and friends can make contributions to the account in lieu of birthday and holiday presents, for instance (who knows what Christmas present to get for a one-year-old, anyway?)