In his latest Forbes.com article, Adam Bergman, discuses the Coverdell ESA –
Formerly known as an Education IRA, a Coverdell Education Savings Account (Coverdell), is a federally sponsored, tax-advantaged trust or custodial account set up to pay for qualified education expenses, such as tuition and fees; the cost of books, supplies and other equipment; and in some situations the cost of room and board.
The main advantage of the Coverdell is that like a Roth IRA, amounts deposited in the accounts grow tax-free until withdrawn. The designated beneficiary of a Coverdell can receive tax-free distributions to pay qualified education expenses. The distributions are tax-free to the extent the amount of the distributions doesn’t exceed the beneficiary’s qualified education expenses. In general, amounts remaining in the account must be distributed when the designated beneficiary reaches the age of thirty, and the earnings portion generally will be considered taxable income of the beneficiary. To prevent this, the funds in a Coverdell can be rolled over into a Coverdell for another eligible family member before the primary beneficiary reaches age 30.
The Coverdell is less common than the 529 plan because the annual contribution limits for a Coverdell are limited to $2,000 per year, per beneficiary for 2018 and are not tax deductible. Any individual whose modified adjusted gross income is under the limit set for a given tax year can make contributions. The income limit for making a maximum contribution now stands at $190,000 for married couples filing joint tax returns, and contributions phase out at $220,000 in 2018. For those not filing a joint return, the limit is $110,000.
The 529 Plan is often considered the best option available to pay for school due to its high contribution limits. 529 Plans have no annual contribution limit. However, there are maximum aggregate limits, which vary by plan. Under federal law, 529 plan balances cannot exceed the expected cost of the beneficiary’s qualified higher education expenses. Limits vary by state, ranging from $235,000 to $520,000. Also, a contribution of $14,000 per year or less qualifies for the annual federal gift tax exclusion. Nevertheless, the Coverdell offers parents that are saving for a child’s education another great option, too.
Coverdell accounts are similar to 529 college-savings plans in that they offer tax-free investment growth when the funds are withdrawn for qualified education expenses and now can both be used to save for K-12 expenses. For example, a parent contributing $2,000 each year to a Coverdell from when the child is born up until the child turning eighteen, assuming a seven percent rate of return, would have $72,758 in the Coverdell at age 18.
However, one of the main differences between the Coverdell and 529 plan, is that Coverdell offers investors a much broader range of investment options and greater flexibility in terms of how the money is used compared to 529 plans. For example, Coverdell’s can be invested in traditional as well as alternative asset investments, such as real estate, whereas 529 plan contributions may only be invested in traditional assets, such as mutual funds.
In general, 529 savings plans are composed of portfolios. Each portfolio is comprised of one or more mutual funds, certificates of deposit, etc. When you choose an investment option for your contributions, you are selecting the portfolio in which those contributions will be invested. Investors are permitted to make investment changes to the 529 plan twice a year.
On the other hand, an investor can establish a self-directed Coverdell. Much like IRAs, Coverdell investments can be invested in almost any asset, other than what is prohibited pursuant to Internal Revenue Code (IRC) Sections 408(m) and 4975. In general, the Internal Revenue Code does not describe what a Self-Directed IRA or Coverdell can invest in, only what it cannot invest in. IRC Sections 408 & 4975 prohibits “disqualified persons” (a lineal descendant or related entity) from engaging in certain type of transactions. For example, so long as one does not use Coverdell funds to buy life insurance, collectibles, or engage in any transaction that directly or indirectly involves or benefits a “disqualified person”, the transaction will not violate the IRS prohibited transaction rules. Thus, an investor may use Coverdell funds to purchase real estate, notes, private business interests, tax liens, cryptocurrencies, and much more, so long as the investment does not violate the rules under IRC Sections 408 and 4975.
Using a Coverdell can be a great and simple option for many Americans to help pay for their children’s education expenses. To determine what investment options are suitable for you, it is advisable that you consult with a qualified financial adviser or investment professional.