How to Use the Coverdell ESA for Maximum Savings

Written by: Kristyn Pilgrim
Updated: 6/02/20

A Coverdell Education Savings Account (ESA) is a special account designated for the future college education of minors, typically set up by parents, and allows families to save for college while receiving tax benefits. Read on for a better understanding of what Coverdell ESA is, how it works, and the best way to use it to maximize savings for your college investment. 

How Does It Work?

Similar to a Roth IRA, funds can be contributed after taxes are paid on them. From there, the earnings can grow tax-free and will not be taxed if used on qualifying education-related expenses. Account holders can contribute up to $2,000 per year per beneficiary. Since the account is designed for parents to save for a child’s college education, no contributions can be made after the beneficiary’s 18th birthday. 

Since Coverdell ESAs can be used to invest in a variety of stocks, bonds, and mutual funds, the money put in typically yields a 7% return. For example, if you began saving $2,000 per year for a newborn child and continued for 18 years, you would eventually have $36,000 saved. Had you invested this into a Coverdell ESA, however, you could have more than doubled your money and ended up with $72,758 by your child’s 18th birthday. 

Who Can Have a Coverdell ESA?

A Coverdell ESA can be formed for anyone under the age of 18 or for those with special needs without any age limitations. The account must be designated as this type of account from the time it is opened, and the appropriate paperwork must be filed. There are certain limitations on who can participate in this type of account based on household income, however. 

Single filers who have a modified adjusted gross income (MAGI) of less than $110,000 and joint filers with a MAGI of $220,000 can contribute to this type of account. Contributors can include parents, grandparents, relatives, and friends of the beneficiary. 

Is a Coverdell ESA a Good Fit?

This type of college savings account is ideal for parents or grandparents who meet some of the following factors:

  • You have multiple children with the hope that they will attend college.
  • You have begun planning for college in the early years of your children’s lives.
  • You have children who currently attend or may attend private elementary or secondary school in the future.
  • Your income falls below the income limitations.
  • You enjoy a high level of flexibility in your investments.

What Are the Qualified Expenses?

Qualified expenses are tax-free, and nonqualified withdrawals are typically subject to a penalty. The unique thing about this type of account versus alternative college savings plans is that the funds can be used for school-related expenses in both elementary and secondary school. 

Services like academic tutoring and uniform expenses can be covered, along with the standard higher education expenses, like tuition and fees. In addition, room and board can be paid through this account as long as the student is at least enrolled half-time. Books, supplies, equipment, and computers, if used for school, would also be an approved form of withdrawals. For special needs students, any special needs-related services could be covered too. 

A common question associated with Coverdell ESAs is what if the child does not need the money, which could occur if the child decides not to attend college or if they receive a scholarship. In that case, the funds can be transferred to another beneficiary, or they can be taken out minus taxes and penalties. 

Considerations When Utilizing a Coverdell ESA

One important consideration when choosing a Coverdell ESA as a college savings pathway is that all funds must be withdrawn before the beneficiary turns 30. (An exception is made for special needs beneficiaries.) 

Conversely, this is not a requirement of some other college savings account types, such as the 529 plan. Being required to use the funds by 30 could be an issue if you saved too much for college and are not able to utilize the funds for a qualified expense. You would still have access to the funds, but taxes would be paid on them, and potential penalties would be enforced. 

Another consideration is that all deposits must be made in cash and are not tax-deductible. Furthermore, if your income surpasses the aforementioned cap, you will no longer be able to contribute to this account. However, corporations and trusts can make contributions without income restrictions. 

How to Get Maximum Savings With a Coverdell ESA

Create a strategy of what you plan to contribute within a certain time frame. 

To maximize the savings you can earn with a Coverdell ESA, you should plan ahead to make the maximum amount of contributions you can make without over- or under-saving. Use a college savings calculator to help determine the predicted costs, then make a monthly plan to get there. Contributing roughly $167 per month will get you to the $2,000 per year max. 

Save the right amount. 

If you have a concern that you might save too much and not have the ability to access it before the beneficiary turns 30, you can consider pairing a Coverdell ESA with another type of savings plan. Be cautious of under-saving, too. Since Coverdell ESAs can be used for kindergarten through high school expenses, you can begin saving early for private education if that is in your future plans. According to the Private School Review, the average cost for private school tuition in 2020 is $11,012 per year. 

Start the account at the right time.

Waiting too late to begin saving through a Coverdell ESA can have drawbacks. With the ability to only contribute $2,000 per year, and only until the child turns 18, the earlier you start to invest in your child’s college savings, the better. 

Work with a financial adviser for direction. 

You can consider working with a financial adviser on how to invest the funds since you can build a portfolio of various investments like stocks, bonds, and mutual funds. These accounts can also be opened through a brokerage firm, who can provide some guidance on how to invest them. When going through a brokerage, though, you should be aware that annual maintenance fees may apply. Some brokers that offer Coverdell ESA options include TD Ameritrade, Scottrade, and Schwab. 

Keep in mind the income limits. 

If you plan to make more than $110,000 per year as a parent saving for college, this plan won’t work for you. An alternative would be a 529 plan, where there are no income limits, and contributions limits are significantly higher. 

Be mindful of the effects this could have on financial aid.

When funds are withdrawn from a Coverdell ESA, they could be reported as income for the student the following year, depending on who owns the account. Up to 50% of the student’s income is considered in the Expected Family Contribution (EFC), which can directly impact an award amount. 

However, these rules do not apply when a grandparent or another relative owns the account since there is no place to report income other than the child and parents on the FAFSA. If a dependent child is both the owner of the account and the beneficiary, none of the assets are counted against financial aid. If the child is the account owner and beneficiary but considered independent of the parents, then 20% of the income is factored into financial aid. Conversely, when a parent owns the account, only 5.64% of assets are factored into financial aid results. 

Learn More

College Finance is here to help you prepare for your college investment. Check out our abundance of resources and helpful guides to assist you in making the best financial decisions. If you or your child are nearing college, and you have not begun saving, there are still numerous ways to make college attendance a reality for your family.