The Coverdell ESA: A Secret Weapon for Education Savings

There are a number of questions that arise when thinking about what kids’ savings for their future is best. And the answer is that all of them have strengths and weaknesses, depending on the use case. As I focus in this article on why the Coverdell ESA is potentially a strong vehicle, I want to frame this conversation in the context that depending on what state you live, the programs that are available, and whom exactly is making the contribution (parents vs. grandparents vs. relatives vs. friends) and the dollar amounts we are working with, you can get to different answers. The key in all of this is actually doing the analysis from a few different perspectives, and I would strongly, strongly encourage seeking a financial adviser and/or tax professional to help you weigh these thoughts.

• The potential risk/reward that you feel comfortable having your child’s education savings in.
• What are the tax benefits and consequences, if any?
• How much/what is the source of the funds?
• What laws in your state apply to the situation? 
• What degree of flexibility do you want to have with respect to the parent and/or child having access to the funds in the account?
• What degree of flexibility do you want to have with respect to how the funds are spent and the potential consequences if they are not spent on qualified educational expenses?
• Does my child have to go to college to benefit from contributions into an education savings account? Do they lose the funds if they aren’t used on education?
• Does a Coverdell account negatively impact their FAFSA later on?

With that all said, let’s talk about what a Coverdell Education Savings Account (ESA) is. A Coverdell ESA is a tax-deferred trust account that allows families to increase investment earnings through tax-deferral, so long as the funds are used for educational purposes. This means that if you invested $1,000 in a Coverdell ESA, and over time it grew to $3,000, assuming the $3,000 was entirely used on educational expenses, you would owe no tax on the $2,000 of growth in the account. Pretty sweet, right?

Contributions in a Coverdell ESA are limited to $2,000/year per beneficiary, and that is across all accounts. If multiple Coverdell ESA’s are established for a beneficiary, that limit applies across ALL of them, so be careful if you have multiple Coverdell accounts floating around for a child. Contributions to a Coverdell ESA are not tax-deductible.

The next logical question is, what constitutes a qualified educational expense? Coverdell ESA’s can be used for primary and secondary school expenses, such as laptops, tablets, special learning materials, academic tutoring, including by the way tutoring for kids who are AHEAD in school. Yes, you can have your child attend an ACT or SAT prep course to help bolster their chance not only of admission, but academic scholarships, through funds saved in the Coverdell and not pay taxes on the usage of those funds.

In addition, of course the Coverdell ESA funds can be used for post-secondary educational expenses at qualified institutions such as college, but they can also be used for expenses going to a qualified trade school or vocational academy. What makes a school “qualified” is that the school is eligible to offer U.S. Federal Student Loans. If the school qualifies for offering that type of financial aid (and most do), then the beneficiary can use the funds. 

Speaking of higher education, let’s talk FAFSA for a moment. If the Coverdell ESA is held with a parent as the account holder, then yes, there will immediately be a negative consequence in a FAFSA application. However, 529 ESA’s and Coverdell ESA’s get much more favorable treatment compared to other types of asset accounts, capping out at 5.64% of the value included in the student’s Expected Family Contribution. But there is a way to circumvent this. While it shows up if the parent is the account owner, it will not show up on a FAFSA if a relative or friend establishes the account. Now the catch to that is, once the student receives a distribution from the Coverdell, it will show up as “untaxed income” on the following year’s FAFSA. So what you in that case is wait until the very last year of schooling to tap into the Coverdell funds because you won’t care what goes on a FAFSA the following year – you’ve graduated and are finished with school! 

In terms of fund strategy, the Coverdell ESA has a much higher degree of flexibility and customization than a conventional 529 plan because it is not a broad-platform plan trying to cover a wide range of families. Each account can be tailored to the child’s and family’s needs. Management of a Coverdell is also more individualized; 529 plans typically use automatic target dates to make strategic adjustments, which can adversely affect performance if, for example, the plan is trying to de-risk at a time where the market is down and de-risking carries a price premium. This type of situation can have a long-term negative impact on the overall returns in the account, whereas an active manager of the Coverdell has the flexibility to potentially avoid that problem altogether. 

However, there are some downsides to the Coverdell ESA and would not be prudent to ignore them. As noted earlier, there are no taxes if distributions are used for qualified educational expenses. If, however, the funds are used for non-educational expenses, they will be taxed as ordinary income and are subject to an additional 10% penalty. Note that this applies only to the growth in the account – you aren’t taxed on the principal, so if there isn’t much growth, you aren’t looking at much of a tax/penalty consequence should you decide to take a non-qualified distribution. Additionally, if the funds are not used by the time the beneficiary turns 30 years of age, they will receive the funds as a distribution and will be subject to income taxes and the 10% penalty at that point.

529 plans have a similar tax treatment, so there’s no advantage to be gained in that aspect. 529 plans in some states do offer some tax break incentives for contributing if you live in the state of the 529 plan, so it’s good to check that and evaluate the benefit against how that 529 plan is being managed. After all, receiving a tax break for contributing only to have the funds grossly underperform what you need is not really a savings at all in the long-term. That said, 529 plans are really strong when it comes to receiving larger amounts of money from family members and friends – they can gift up to $75,000 in one year (5x the normal gifting maximum) into a child’s 529 plan with no negative tax consequence. If they choose to do that, they do have to wait 5 years before making any other contribution. That said, grandparents contributing to a 529 plan is an outstanding way to secure their grandkids’ educational future while at the same time sheltering monies from estate taxes.

Another vehicle that is considered as an alternative is to setup a Uniform Gifts to Minors (UGMA) account. This account is established with the minor as the account holder and the adult creating the account as custodian. When the minor turns to the age of majority (which varies from state to state, do check this!) they become the account owner and can do with the funds what they wish, without additional tax consequences from using the funds on non-educational expenses. However, UGMA accounts are not treated well at all when it comes to FAFSA, have potential taxes every single year (making the parent’s tax filing more complicated and potentially having tax liabilities to handle annually), and have potential issues with being abused by less-than-trustworthy guardians and/or the child themselves when they become of age, because it is their account at that point to do what they wish. I’ll let you fill in the thought bubble on all the things that could happen there.

To wrap up, the Coverdell ESA is a fantastic vehicle that can be used through the entirety of a child’s development to support them in growing up to being a terrific adult. It offers a high degree of flexibility, while at the same time providing potential tax advantages and minimizing downside consequences no matter what the child chooses to be growing up.  That said, it is important to consider all the factors and circumstances surrounding your individual situation before making a decision on which savings vehicle or combination of vehicles is best for you, and would strongly recommend consultation with a financial advisor and/or tax professional prior to starting any ESA. Please feel free to reach out if you have any questions.