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How a Coverdell education savings account helps with education costs

Mom helping daughter with homework
MoMo Productions/Getty Images

Helping a child save for college tends to be one of the biggest concerns parents and guardians have. In addition to their health and safety, you want to ensure they have the means to grow into productive and purposeful adults.

When most people think about college savings accounts, 529 plans are what come to mind, but that's not the only option. Coverdell education savings accounts are another way to save for educational expenses. Even better, they can be used in conjunction with a 529 plan.

Here are the details you need to know about them—plus some insight into how this savings approach can benefit your family.

What is a Coverdell education savings account?

A Coverdell education saving account is a custodial account you can set up to pay qualified education expenses for the child named on the account. As the person setting up the account, you are the custodian and your child is the beneficiary. You get to choose how the money put into it is invested. It grows tax-deferred and is tax-free when it's withdrawn.

One unique feature of Coverdell accounts is that while the money in them can be used for college costs, it can also go toward qualifying K-12 expenses. This can make it easier for you to provide for your child throughout their schooling. Income limits affect who can create this type of account, however, so they are not available for all families.

Who can open a Coverdell account?

Anyone can create the account, but it is generally done by parents, grandparents or legal guardians for their dependent kids or grandkids. However, Coverdell's involve certain other strict limitations. For one, the beneficiary must be younger than 18 at the time or identified as a special needs beneficiary. Additionally, the account must be clearly designated as a Coverdell education savings account at the time it is created.

Family income caps, which are adjusted yearly, also affect who is eligible to create a Coverdell account. The 2022 and 2023 limits for custodians' total modified adjusted gross income (MAGI) are:

  • $220,000 for a married taxpayer couple
  • $110,000 for single taxpayers or a married couple filing separately

Earning more than these amounts means you can't open a Coverdell account.

How Coverdell contributions work

Coverdell contribution caps for 2023 are $2,000 per year per child. This applies no matter how many different Coverdell accounts have been set up—the total amount put into them in a year cannot exceed $2,000 for any one beneficiary.

Contributions have to be in cash, and they are not tax-deductible. Anything added to the account must be done so by Tax Day for the previous tax year. This means that if you're filing your taxes in April 2024 for the 2023 tax year, you can contribute to a Coverdell right up until that April 2024 filing deadline and have it count toward 2023.

Trusts and companies can also make Coverdell contributions, and there are no income caps for those entities. However, once your child reaches age 18, contributions can no longer be made to the account (unless the child is designated a special needs beneficiary).

Decide exactly how your money is managed

Another unique feature of a Coverdell is that the account custodian gets to decide exactly how the money is invested and managed. You can invest the contents of your Coverdell with any financial institution that also handles IRAs, and the money can be put into any qualifying investment the financial institution offers—with the exception of life insurance.

This gives you the freedom to work with a values-based institution and to make personal decisions about what types of stocks, bonds and funds your money is involved with.

Rules for Coverdell payouts for education

When it comes time to use the money you've set aside from your child's schooling, you'll have to abide by a few rules.

What can the money be used for?

Once the child is enrolled in school, Coverdell funds can be used tax-free for:

  • College tuition, room and board, equipment, tutoring and books
  • K-12 tuition up to $10,000
  • Special needs services

What is the Coverdell ESA withdrawal penalty?

If the child takes out more from the Coverdell than their expenses actually require, the difference will taxable. There is also a 10% penalty when the money taken out isn't used for qualified expenses.

When a distribution is made, Form 1099-Q is sent from the Coverdell to the child. If the withdrawal does not exceed the qualifying expenses, then there is no tax due.

What happens to unused Coverdell funds?

Unused Coverdell funds can be rolled over into another Coverdell account or into a 529 plan before the child reaches age 30. You have 60 days from the date of withdrawal to complete the rollover, and you can only do a rollover once every 12-month period. You can also change the beneficiary to use the account to another child.

If there is still money in the account on the beneficiary's 30th birthday, it will have to be distributed within 30 days after it—except in cases of special needs beneficiaries. The unused amount will be subject to tax as well as the 10% penalty. In the unfortunate event the beneficiary passes away before reaching age 30 and any money is in the account, it will need to be distributed within 30 days of their death.

When does a Coverdell ESA make sense?

Coverdell education savings accounts do offer advantages for eligible participants, but some people stand to benefit more than others. Every family's financial situation is different, but a Coverdell account may make sense if you identify with the following criteria:

  • Your MAGI income is below the phase-out threshold
  • You want to contribute up to $2,000 per year
  • Your child is under age 18
  • You intend for the beneficiary to use all the funds before they turn 30
  • You don't plan to make contributions after the child reaches age 18
  • You want to have control over how the funds are invested

Comparing Coverdell vs. 529 side by side

Both Coverdell accounts and 529 plans allow you to create educational savings for your child. There are benefits and drawbacks to both.

Coverdell education savings account
529 plan
Income eligibility for contributor
Capped at $110,000 single and $220,000 married
Qualified expenses for K-12 and college
Qualified college expenses and up to $10,000 for K-12 tuition
How long can contributions be made?
Contributions can be made up to age 18 except in the case of special needs beneficiaries
No restriction on age limit
Transferable to a family member
Tax status
Tax-free growth and withdrawals
Tax-free growth and withdrawals
Age limit for distributions
Must be used by beneficiary's 30th birthday except in case of special needs beneficiaries
No age limit
Contribution limit
$2,000 per year per child
Determined by state
FAFSA impact
Considered an asset of the contributor
Considered an asset of the contributor
Investment limits
Limited and controlled by the financial institution
10% for withdrawals beyond qualified expenses
10% for withdrawals beyond qualified expenses

Can you have a Coverdell and 529 plan?

You can contribute to both 529 plans and Coverdell accounts if you want to. Just remember that the gift tax exclusion will apply to your total contributions to both accounts. Another important point to keep in mind is that money should be able to be moved from a Coverdell to a 529 without any tax implications.

Ultimately, Coverdell accounts can be a great way to begin saving for your child's education and be able to decide how exactly your money is invested. These plans can help you ensure a positive future for your child while allowing you to take advantage of some useful tax breaks. With this reassurance, you can focus on the elements of their upbringing that matter most to you and your family. Connect with a financial advisor to learn more about saving toward future education costs and the options available to you.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.

Offered through a brokerage arrangement with Thrivent Investment Management Inc. 529 college savings plans are not guaranteed or insured by the FDIC and may lose value.

Consider the investment objectives, risks, charges, and expenses associated before investing. Read the issuers official statement carefully for additional information before investing.

Investigate possible state tax benefits that may be available based on the state sponsor of the plan, the residency of the account owner, and the account beneficiary. Consult with a tax professional to analyze all tax implications prior to investing.