When it comes to the best way to save money for college, it’s 529 this, 529 that. Usually, the conversation pretty much ends there.
But it would behoove families to also look at another tax-friendly savings tool that can put a dent into the high cost of higher education. Coverdell Education Savings Accounts, or ESA’s, have been around since 2002, but the plans are hardly a household name compared with 529 accounts.
Tellingly, when the SavingforCollege.com educational website surveyed its readers two years ago, it found that more than 84% were not familiar with Coverdells and less than half were aware of the educational expenses the accounts covered.
If one of your goals for the new year is to start building a college fund for your child or grandchild, Coverdells have attractive features.
Like 529s, Coverdells allow assets to grow tax-free as long as distributions are used for a long list of qualifying college expenses. The expenses also cover qualified public, private and religious elementary, and secondary education expenses.
In addition, the accounts offer more investing flexibility since the money can be invested in stocks, bonds, and mutual funds. In contrast, 529s are limited to mutual funds, albeit with plenty of funds to choose from.
Coverdell accounts can be set up by parents and grandparents at mutual fund companies, investment firms, or banks for the benefit of a particular child. The contributions are not tax deductible — a key point to remember — and there is a $2,000 annual limit. That limit applies even when a student has more than one account – you can still only deposit a total of $2,000 across all of the accounts over the year.
What’s the definition of a qualified expense?
It’s a broad list that includes tuition, books, and fees, and also the cost of computers, peripheral equipment, software and even internet access. With remote learning a necessity for many families, desks, desk chairs and other related furniture used in home-based learning could also qualify, some financial planners said.
According to the Internal Revenue Service, a qualified expense must be “required for the enrollment or attendance of a designated beneficiary at an eligible educational institution.” Computer software for sports, games or hobbies are not covered “unless predominantly educational in nature,” the IRS said.
The Coverdell accounts are not for everyone, especially those with high income who could face phase-out provisions on contributions.
While the $2,000 limit may not sound like much, every dollar helps offset what might need to be borrowed.
In addition, contributions to the educational accounts must end when the student turns 18, and withdrawals must be distributed by the time the beneficiary turns 30, unless the benefits are for a special needs child.