Coverdell ESA Pros and Cons

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By Paul Cullen, CIP, CRSP, QPA, TGPC

Can a customer open an IRA for his child to pay the child’s education expenses?

I will start with the caveat that it is always best for your customer to consult with an accountant or financial professional to assist him in this decision, but you could help educate him on some possible choices. To open a Traditional or Roth IRA in your child’s name, the child must have earned income from working, but most children will not meet this requirement. If the child had earned income, the child would likely be eligible for a Traditional or Roth IRA contribution, but not in excess of the child’s earned income.

The purpose of Traditional and Roth IRAs is to use the assets for retirement. But there is a penalty tax exception for higher education expenses if the child were to take a Traditional or Roth IRA distribution. She would not be on the hook for the 10 percent early distribution penalty tax. However, a withdrawal from a Traditional IRA used for her education would still be subject to ordinary income tax, and Roth IRA earnings would in all probability be taxable .

Another option for the minor is a Coverdell education savings account (ESA), sometimes referred to as an “Education IRA.” An ESA works much like a Roth IRA where contributions go in on an after-tax basis, and if your customer uses the ESA for qualified education expenses, the earnings are tax- and penalty-free.

What are some benefits of an ESA compared to other types of accounts?

Unlike Traditional IRAs, Roth IRAs, UTMAs, UGMAs, or other nonqualified accounts, earnings are tax-free if used for qualified education expenses. ESAs work very similarly to their “cousin,” the qualified tuition program (also referred to as a “529 plan”). One benefit of the ESA over the 529 plan is that there may be FDIC insurance coverage, depending on the investments—529 plans are often invested in mutual funds where there is no FDIC coverage.

Probably the main benefit of an ESA, however, is that there is no limit on distributions used to pay for qualifying elementary and secondary (K-12) or higher education expenses. 529 plans were initially intended only for higher education expenses, but new tax reform legislation enacted in 2017 permits the use of 529 plan assets (beginning in 2018) for qualifying elementary and secondary education tuition up to $10,000 per year. Like ESAs, 529 plans have no limit for qualifying higher education expenses. ESAs are not limited to this $10,000.

What’s more, ESAs are offered by many financial organizations, whereas any given state’s 529 plan generally is administered, and investments offered, by a single organization that has won that state’s business.

What are some of the pitfalls of using an ESA compared to other accounts?

If your customer decides to use an ESA to save for a child’s education, he is limited to a $2,000 contribution per year, and can contribute only until the child reaches age 18. So, the maximum that can be contributed to an ESA is $36,000. With the rising cost of higher education, $36,000, even with compounded earnings, may not be enough to pay for a significant portion of your child’s education expenses. 529 plans have much higher contribution limits as set by the individual states, which often are aggregate balances of up to $300,000, or even more.

Like Roth IRAs, ESA rules subject the contributor to maximum income restrictions, so some individuals may not be eligible to fund an ESA. 529 plans do not have income restrictions. Also, ESAs require the assets to be used up by the child’s 30th birthday. Most 529 plans do not have a maximum age. Some states even offer a state tax benefit for 529 plans, such as a deduction or credit, to encourage education savings in that state. These state tax benefits generally are not available for ESA contributions.

Finally, there is always the chance your child will not incur qualified education expenses.   Perhaps she starts a business or gets her education expenses paid in another way. If this is the case, for both ESAs and 529 plans, she would then be required to pay income tax and an additional 10 percent penalty tax on the earnings, unless the assets are transferred to a qualified family member who is able to use them for education.

Where can my client find more information on ESAs?

It is important that your customer weigh all the options when saving for his child’s education and future. Your customer should consult with a competent financial professional when planning for his child’s future. IRS Publication 970 is a great resource for more information. It addresses the rules and qualifying education expenses for ESAs and 529 plans, as well as the uses of Traditional and Roth IRA assets for education expenses.