It sometimes seems like when it comes to college-savings vehicles, 529s are the only game in town.
But investors are doing themselves a disservice if they don’t also look at another savings tool available: Coverdell Education Savings Accounts (ESAs). Like 529s, ESAs are a tax-favored way to save for education expenses. Both types of accounts allow assets to grow tax-free when distributions are used to cover qualifying expenses.
But ESAs have a nice additional feature that 529s lack: They offer more flexibility in investment choices than 529s. ESAs can be invested in stocks, bonds and mutual funds, while 529s are limited to mutual funds.
ESAs were introduced in 1998 as Education IRAs. They were renamed in 2002 in honor of the late Sen. Paul Coverdell, who had been the primary champion of these plans in the Senate. Their benefits were made permanent by the American Taxpayer Relief Act of 2012.
Accounts are typically set up at mutual-fund companies, brokerage firms or banks by parents and grandparents, who then make nondeductible cash contributions to the accounts.
There is an overall $2,000 annual limit on contributions to all ESAs for the benefit of a particular child. A beneficiary may owe a 6% excise tax every year that excess contributions are in his or her ESA.
There are limits that can discourage investors with large incomes from setting up an ESA. Those filing joint returns must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) to make the $2,000 maximum contribution. The maximum is phased out for joint filers with a modified adjusted gross income falling between $190,000 and $220,000 (between $95,000 and $110,000 for single filers).
Once set up and properly funded, however, the assets grow tax-free, just as they do in a 529, and offer tax-free distributions as long as the money is used for qualified educational expenses.
As a result of the pandemic, both 529s and ESAs have benefited from a broadened interpretation of what constitutes qualified expenses. In this era of increased remote-learning, costs for such items as computers and peripheral equipment, software and internet access are now typically allowed in addition to tuition, books and fees.
“Coverdell is a way to cover these costs,” says Mark Kantrowitz, publisher of Savingforcollege.com, a website that provides information on college savings plans. “As long as the costs are reasonable.”
Section 26 USC 529(e)(3) of the Internal Revenue Code is precise in defining a qualified expense. It must be “required for the enrollment or attendance of a designated beneficiary at an eligible educational institution.”
In discussing computers and the like, the code says they “are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled.” And it warns that allowable costs do not include those “for computer software designed for sports, games or hobbies unless the software is predominantly educational in nature.”
Meanwhile, in light of the lockdowns, financial advisers say other items may also fall into the category of qualified education expenses.
“While not specifically mentioned in the tax code or in IRS publications, home desks and chairs and other related furniture for educational purposes fall under the broad category of supplies and equipment related to online learning,” says Ed Slott, president of Ed Slott & Co., a Rockville Centre, N.Y., tax consulting firm. “Schools can easily make the case that this equipment is required for enrollment and proper home learning.”
To be sure, ESAs have drawbacks in comparison with 529s. In addition to their income and contribution limits, ESAs are also age-limited, while 529s are not. Contributions must end when the student turns 18 and withdrawals must be distributed by the time the beneficiary turns 30.
Furthermore, 529s can take advantage of five-year gift-tax averaging—whereby up to five years of contributions, or $75,000, can be made all at once—but ESAs cannot. And 34 states offer income-tax breaks to 529s, but none do so for ESAs.
A portion of an ESA withdrawal may be taxable, even when used for college, if a family claims an American Opportunity or Lifetime Learning credit (federal tax credits for qualified education expenses for eligible students) in the same year. That’s because the tax law does not permit “double dipping” by claiming more than one tax break for the same expense.
Unused ESA assets remaining in an account can be rolled over without triggering a tax penalty to another ESA for a member of the beneficiary’s family, including in-laws, spouses and first cousins. Funds in an ESA can be transferred tax-free to a 529 plan, but the beneficiary must remain the same. However, funds in a 529 plan cannot be transferred to an ESA.
An additional benefit of an ESA: If a person received a military death benefit from Servicemembers’ Group Life Insurance, all or part of the payment can be rolled over to an ESA for a member of the beneficiary’s family. These distributions are an exception to the $2,000 annual limit rule, meaning any amount can be rolled over to an ESA. The military death benefit can also be rolled over to a Roth IRA.
Information about ESAs can be found in IRS Publication 970, “Tax Benefits for Education.”
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