To be honest, we are not huge fans of the Coverdell ESA. Beyond limiting you to funding educational endeavors alone, there are some other pitfalls that people can fall into if they don’t understand the Coverdell rules.
That said, it remains a popular instrument. It can be used not just for college expenses, but for K-12 education as well. So, if you are using Coverdell to save for your children’s education, here are some things to understand in order to make it work for your family.
1. Understanding Income Limits
If your household income grows too large, that is a problem where the Coverdell is concerned. In 2020, if your adjusted gross income is $110,000 or more ($220,000 if filing a joint return), you are not eligible to use a Coverdell ESA. So be aware of these income limitations as you consider your options.
2. Spending only on qualified education expenses
Coverdell is a savings instrument for education only. Be aware of the qualified education expenses allowed through the Coverdell ESA. They include:
- Tuition, fees, academic tutoring, special needs services, books, supplies, and other equipment needed for the enrollment or attendance in a K-12 or higher education institution
- Room and board, uniforms, transportation, and supplementary items and services (for instance, extended day programs) which are required or provided by the school
- Any computer technology, equipment, or Internet access and related services, if the technology, equipment, or services are to be used by the student or student’s family during any of the years the beneficiary is in school.
As long as you are spending within those parameters, the Coverdell works fine. If Junior decides to join the workforce after high school and those funds were not used for K-12, Coverdell funds can’t be used to help with rent, buying a first car, or other non-education expenses.
3. Understanding How Savings Will Impact Financial Aid eligibility
While we are not advocates of going into debt—especially large amounts of debt—to get that college degree, we understand that for some, a small amount of debt may be unavoidable. That’s why it is important to understand that a Coverdell account can negatively impact your child’s eligibility for financial aid.
Similar to a 529 plan, up to 5.64% of the value of a Coverdell ESA gets included as part of the Expected Family Contribution (EFC) in the Free Application for Federal Student Aid (FAFSA) process. Also, while a parent or student-owned account will not be included in federal income taxes, a grandparent’s Coverdell does not work the same. So if a grandparent takes out $10,000 to contribute to a grandchild’s college, it counts as income to the student, assessed on the FAFSA up to 50%. So for that $10,000 contribution from Nana and Pop-Pop, the grandchild’s EFC will be increased by $5,000. This means less access to financial aid.
4. Contribution Limits
Be aware that contributions on a Coverdell are limited to $2,000 per year per beneficiary. If you start early and keep up that commitment, $2,000 a year can potentially turn into a nice increase, but there are, of course, no guarantees on returns.
What is undeniably positive about the Coverdell ESA is that it grows tax-deferred AND is distributed income-tax-free for those qualified education expenses. So, as an instrument that protects you from certain tax burdens, Coverdell is similar to a 529 plan.
While we are not Coverdell’s biggest cheerleader, with an understanding of the rules and limitations, a Coverdell ESA could work for you. Just understand all you need to know before jumping in with both feet.