Coverdell education savings accounts: how they work, who qualifies, and why you might want to choose one

• A Coverdell education savings account is an investment vehicle that lets you save toward a student’s education expenses.
• All investments are tax-deferred if used toward qualifying education costs when they are distributed.
• The maximum you can contribute every year per beneficiary is $2,000 across all Coverdell accounts.
• Read more stories from Personal Finance Insider.

A Coverdell Education Savings Account (ESA) is a way to save for a child or grandchild’s college costs while also receiving tax advantages. It works like any other investment account with an owner and a beneficiary — you’re the owner, the child is the beneficiary. Coverdell ESAs are similar to 529 plans, with a few key differences in areas including eligibility and contributions limits.

How a Coverdell ESA works

With Coverdell ESAs, you can contribute as much as $2,000 per year per beneficiary — the same maximum applies even if it’s spread across multiple Coverdell accounts. You can use the funds for costs for K-12 schooling as well as college. Contributions to a Coverdell account are not tax deductible, but distributions from it are tax free when you use the money toward qualifying costs related to education.

These accounts are structured similarly to regular investment accounts in that they have an owner (you), and a beneficiary (the child). The owner controls the investments, and a Coverdell account’s investment options are more varied than with a 529 plan.

“If you wanted to invest in specific stock, ETFs, or mutual funds, a Coverdell has an advantage [over 529 plans] in that you can invest in a lot more options,” says Kelly Welch, vice president and wealth advisor at Girard Advisory Services, LLC. “You can buy any mutual fund or ETF, really, that you want.”

More control means you also have to make sure you’re switching to more conservative options as college nears. “Double check and do your research as they’re getting closer to college age that it’s invested appropriately based on the time horizon of when they’re going to need it for school,” Welch says.

There are several rules and requirements that come with Coverdell ESAs.

Who qualifies for a Coverdell ESA?

There are three basic requirements to qualify for a Coverdell ESA:

• The beneficiary must be under age 18 or special needs when the account is opened.
• The account needs to be specified as a Coverdell account when it’s opened.
• The document that creates and establishes the account must be in writing.

Furthermore, the contributor must meet the income limit requirements to contribute the full $2,000 — which is $95,000 for single tax filers, and $190,000 for married and filing jointly households. If you make between $95,000 and $110,000 (for single filers) or between $190,000 and $220,000 (for married filing jointly filers), you can still contribute to a Coverdell, but the maximum contribution limit is lower. Anyone making over those amounts cannot open a Coverdell account.

What are the contribution limits for a Coverdell ESA?

You can contribute a maximum of $2,000 annually, across all Coverdell accounts. Thus, you can open several different Coverdell accounts per beneficiary, but the most that can be contributed in any year is $2,000. 

How do Coverdell ESA distributions work?

If you withdraw and spend the money in a Coverdell ESA toward appropriate education expenses, you won’t pay any taxes or fees. “Historically, you could only use [the funds] for tuition,” says Welch. “It’s not just tuition anymore.”

Qualifying education expenses can include items like tuition, room and board, books, and potentially certain kinds of transportation or technology. If you withdraw the funds to be used on anything other than education-related costs, you’ll pay regular taxes on those funds plus a 10% penalty. 

Additionally, the beneficiary must use the funds by the age of 30 in a Coverdell ESA.

If you can’t use the funds by the age of 30, they can be transferred to another beneficiary to use on their education expenses to avoid the taxes and fees. “You want to make sure you’re least giving it to someone else who can use it for education-related purposes,” says Welch.

Coverdell ESAs vs. 529 plans 

Coverdell ESAs and 529 plans are both tax-deferred college savings plans. However, there are several essential differences between the two in terms of eligibility, contributions, distribution of funds, and which investments you can choose.

	Coverdell ESAs	529 plans
Eligibility	Beneficiary must be under 18 years old when the account is started Account owner must make less than $95,000 when filing single or $190,000 when married filing jointly.	No age limit on when it can be established. No income limitations on who can open a 529 plan
Contributions	$2,000 or less per year	No limits
Distributions	Must be made by age 30	No limits
Investment selections	Larger choice in investment options	More limited choice in investment options

Should I use a Coverdell ESA?

Whether or not you should choose a Coverdell ESA depends on your specific situation. It can work for you if you want to be hands-on with your investment options and aren’t looking to gift a lot of money. For the most part, Welch says that Coverdell accounts are popular with grandparents who want to give less than $2,000 to their grandchildren for college.

Who might not want to take advantage of a Coverdell ESA? Someone looking to frontload their contributions to maximize the number of years of interest might prefer a 529 plan, according to Welch.

“With Coverdell, you’re limited to $2,000 per year, per child,” Welch says. “If people want to give $10,000 to each of their grandkids, you can do that in a 529 in one year, where it would take 5 years in a Coverdell.”

Finally, Welch says not to forget that you need to keep an eye on how Coverdell funds are invested, being sure to move to more conservative bonds as time goes on. “What you don’t want to happen is it’s sitting all in stocks at the beginning of the year, and the market’s off 5%, and you needed that money for your tuition bill Jan. 20th.”