Do Coverdell ESAs belong in your education plan?

Now that you can use your 529 account for K-12 tuition (thanks to the TCJA passed in December 2017), should a Coverdell Education Savings Account (or “ESA”) have a place in your education planning? ESAs are often considered a low-income substitute for a 529and I think that’s a shame. Let’s review the facts so you can decide what’s right for your family.

First, what is an ESA? An ESA is similar to a 529. From birth through age 17, each child’s account can accept up to $2,000/yr. Distributions, including growth, are tax free as long as the account is used for the child’s education costs. Qualified costs include not only tuition and room and board, but supplies and tutoring, same as for a 529 plan.

Other than the annual $2,000 limitation, how does an ESA differ from a 529?

  • Funds remaining in an ESA after age 30 are subject to a 10% excise tax.
    • There is no “expiration date” for 529 accounts
  • You cannot make contributions to an ESA on or after the beneficiary’s 18th birthday
    • There is no age limit for 529 accounts
  • ESAs have more investment options (not limited to state plans)
    • 529 accounts are limited to each state’s plans
  • There are no state or federal tax benefits for ESAs
    • Some states offer tax benefits (deductions and credits for 529 contributions
  • You cannot contribute to an ESA if your MAGI is > $110k (single) or $220k (MFJ)
    • There are no income limit for 529 contributions
  • You can make contributions to an ESA until April 15
    • 529 deadlines vary by state and may be as early as 12/31
  • ESA’s have an annual contribution limit of $2,000/year per beneficiary
    • You can frontload a 529 for 5 years in advance ($75k in 2018)
  • You can transfer your ESA to a 529 account
    • You cannot transfer 529 funds to an ESA

Here’s the kicker: while 529 funds can now be used to pay for grades K-12, you are limited to spending only $10k/year. Many private schools cost more than that. An ESA can fill that gap.

So what about income limitations? Not a problem. Anybody whose MAGI is below the above limits can contribute to the account. You simply gift the contribution to a qualifying person who will then contribute to the ESA. (Your parents may even be happy to contribute without your gift) Or you can set up an UTMA/UTGA account for your child, gift $2,000 to her each year, and let her make the ESA contribution. All perfectly legal.

You can simplify by using one UTMA for all of your children and gifting 2 years’ worth of contributions to the UTMA before 4/15 every other year. Ex: Deposit $8k in little Amy’s UTMA in January 2020 for both Amy and her brother, David. $4k will go into Amy’s ESA for 2019 and 2020 and you’ll do the same for David. Repeat in January 2022.

To get maximum bang for your ESA savings, you should invest in a properly diversified portfolio of equity mutual funds or ETFs. To do so, your financial plan should allocate enough savings to pay tuition out of pocket when the market is in a slump. By doing so, you’ll use the ESA only when it’s at peak value and pay out of pocket (saving your ESA for future tuition) when the market is down.

Of course, ESAs are most beneficial if you begin contributing when your children are very young and you can wait at least 12 years to use them. Because of the age 30 penalty, you should plan to empty the ESA before you spend your 529 accounts. Be prepared to transfer any remaining ESA balance to a younger beneficiary if the account is not emptied by the time the primary beneficiary reaches age 30.

So what about that measly $2,000/year limit? Let’s say you start an ESA when your child is born and max it out the beginning of each year with $2,000. Average annual returns are 7.5%.

chart
Life-changing? Probably not, but meaningful. And I’m certainly not one to recommend you pass up tax-free income. You can open ESAs at most any online custodian.

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