Did you know 529 plans are not the only way to save on taxes while saving for college? The Coverdell Education Savings Account or better known as an ESA is another great way to save for college and is even better than a 529 plan in some instances. Let’s take a look at what it is and how it works.
A Coverdell Education Savings Account is basically a custodial account (or trust account) set up for the purpose of paying qualified education expenses for the beneficiary that you want on the account. There are some things that the IRS requires for this account to be set up.:
When you first start the account your designated beneficiary needs to be under the age of 18 (or can be a special needs beneficiary).
You need to designate the beneficiary when you first set up the account
The document to create and govern the account must be in writing and meet certain requirements. (This is usually done by the financial company you are using).
You can contribute to your Coverdell account to pay for the beneficiary’s qualified education expenses. These contributions must be made in cash and are NOT deductible. You or any individual who wants to make contributions to the plan must be under a limit for AGI (Adjusted Gross Income) set each tax year. Organizations (like corporations and trusts) can also contribute regardless of their adjusted gross income. You need to make any contributions by the due date of your tax return. This does not include extensions. There is no limit to the amount of accounts that can be established for a beneficiary but the total contribution to all accounts for that person cannot exceed $2,000 (2015) for any given year.
The beneficiary of the Coverdell can then receive tax-free distributions to pay qualified education expenses. These distributions are tax-free to the extent the amount of the distributions does not exceed the beneficiary's qualified education expenses. If a distribution exceeds the beneficiary's qualified education expenses, a portion of the earnings is taxable. Amounts remaining in the account must be distributed when the designated beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary. Certain transfers to members of the beneficiary's family are permitted.
There are two major advantages of using the Coverdell ESA over the traditional 529 plan. The first is that it allows you can use the funds in your Coverdell to fund pre-college expenses – you can’t do this with a 529 plan. The other being that you can self-direct your investments. Think of it like an IRA versus a 401k. In a 401k you are limited in your investment options among other restrictions. With an ESA you can invest in almost any investment. These two reasons alone make them worth looking into. And yes, you can have both a 529 plan and an ESA. Consult with your tax professional or financial advisor to see what works best in your situation.