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What Is A Coverdell Education Savings Account (ESA) And How It Works

August 19, 2021

Today we’re going to talk about the Coverdell Education Savings Account.

First, it’s an education savings account that you as a parent or a grandparent can set up for your child or grandchildren which allows you to make contributions to a plan. The plan allows you to invest that account and pay no taxes on the gains within that account.

The best part is, you can take those gains out completely tax-free and penalty-free to pay for that child’s qualified out-of-pocket education expenses. This would be expenses from pre-K through college.

This is Not a 529 Plan.

This Education Savings Account is a little different than a 529 plan. Most parents are familiar with the 529 plan – which is still a great plan – but that’s more of a savings plan. You cannot self-direct, and typically in the past, it’s been more used for college expenses.

The Coverdell Education Savings Account has been around for a long time. It’s always been an account that you can self-direct, and you can take the earnings out completely tax-free and penalty-free to pay for education expenses.

These are expenses that you might be paying for your child right now, using your out-of-pocket money (which is your most expensive bucket of money).

If you’ve got $20,000 in education expenses for your child, and you’re using your earnings, you have to make more than $20,000. This is because you have to pay taxes on your money, and then be left with enough money to pay those education expenses.

Let the Investments Pay for Their Education.

Switch your mindset to that of an investor for a second. If you have investments that can make that same $20,000, make the investment in the Coverdell Education Savings Account.

The difference is that when you earn $20,000 in an education savings account, you have $20,000… not $20,000 minus taxes.

It Pays for Qualified Academic and Vocational Education Expenses.

The expenses that can be paid out of the Coverdell include tuition, uniforms, etc. (if your kids are going to private school). If they are not going to private school, you could still pay for computers, iPads, tutoring, certain afterschool programs, and college-related expenses.

Even if they decide to go to a vocational school, a lot of the funds in a Coverdell Education Account can be distributed tax-free and penalty-free to pay for equipment and whatever vocational school that they attend. We wanted to bring up this account because it’s not well-known. Few people know about it because it’s primarily self-directed. For self-directed investors who are already self-directing Roth IRAs, traditional IRAs, maybe SEPs and SIMPLEs, HSAs, we strongly advise that you start looking at the Education Savings Account as well.

Partner the ESA with Other Accounts.

You can put up to $2,000 per child per year in a Coverdell Education Savings Account. That savings account can be partnered with your other accounts, and it grows completely tax-free for qualified expenses.

We must mention that there are some dates to keep in mind with this account type. For one, once the child reaches age 18, you’re no longer able to make additional contributions to that plan. Their 18th birthday is the last day you can make contributions to that plan. Get them set up early. Start making contributions. Get them working.

Once the child reaches 18 years old, you can still invest in it until the child reaches age 30.

People typically ask, “what happens when my child reaches age 30 and there’s still money left over in the Coverdell education savings account?

Here’s what you can do currently when your child reaches 30 years old…

Currently, you can transfer the beneficial ownership of that account down to another child. The only requirement is that the new child beneficiary has to be under the age of 30. Here’s a scenario for you.

  • You set up a Coverdell Education Account for your child.
  • They don’t use all the money.
  • If there’s still money left in the ESA… you transfer that account down to your next child, your youngest child, or grandchild.

You can transfer the beneficial ownership so that another child in your family has the opportunity to use the account for its intended purposes, which is to pay for education expenses completely tax-free.

We hope that this was helpful to you.

If you are interested in establishing your own Coverdell Education Account that can be self-directed, contact us.

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