Coverdell ESAs- Planning for Higher Education
Saving for College with Tax-free Education Savings Accounts
Jun 23, 2009
Recent polls indicate that most Americans are concerned about their ability to pay for their children's higher education. While a college graduate on an average can earn about twice as much as an high school graduate, the cost of higher education has increased sharply in the past two decades. Because of the increasing cost of higher education, it is important that parents start planning for their children's higher education as early as possible.
According to research done by Mary Specht and Anthony DeBarros for USA Today, the average cost of education for an in-state, first-year full-time freshman increased by 38.1% from 2002-03 to 2006-07. Such a drastic increase means that traditional saving instruments like Certificates of Deposits (CDs) are ineffective in saving for college education.
Coverdell Education Savings Accounts
Previously known as Education IRAs, the ESAs were established to help parents save for their children's higher education and K–12 education expenses. A Coverdell account is similar to a Roth account, the only difference being that an ESA is for saving for education instead of retirement. Contributions to an Education Savings Account are not tax deductible, but the amounts deposited grow tax-free until they are distributed.
Coverdell ESAs Rules and Guidelines
IRS Publication 970 provides some guidelines for opening and maintaining ESAs.
- Designated beneficiary must be 18 or under when the account is established (an exception is allowed for special needs beneficiaries).
- Contributions cannot be made after the beneficiary reaches 18 unless the beneficiary is a special needs beneficiary.
- There is no limit on the number of accounts that can be set up in the name of a beneficiary, but the total contributions cannot exceed $2000 in an year.
- An Education Savings Account can be opened in the U.S at any bank or other financial institution that offers the services.
- Distributions from ESAs are not taxable as long as they are used for qualified education expenses at an eligible institution.
- In order to establish a Coverdell ESA, the Modified Adjusted Gross Income (MAGI) of the person who contributes to the ESA should be less than $110,000 ($220,000 if filing a joint return).
- All contributions must be made in cash.
- If there is a balance in the Coverdell account when the beneficiary reaches age 30, it must be distributed within 30 days. At the time of distribution, the earnings portion of the distributed amount will be taxed and subjected to an additional 10% tax.
- It is possible to roll over the full balance in an Education Savings Account to another family member and thus avoid the taxes and the 10% penalty.
Providing a college education is the best investment that parents can make for their child. Considering that there is high competition for the available financial aid, planning for a child's education is extremely important. Otherwise a child may end up with considerable student loans which will burden him for the rest of his life.
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