Coverdell Educational Savings Accounts (ESAs) are a useful source for education funding. Often, these accounts are overlooked because of their limitations. By understanding ESA rules, proactive parents can provide kids money education not just education funding.
Understanding the ESA Rules
Contributions: Anyone may contribute to an ESA for a child under 18 years of age. Each kid can have up to a total $2000 per year contributed on their behalf. The contributors are subject to income limits that start phasing out starting at $190,000 for couples and $95,000 for singles in both 2013 and 2014. Folks with income above these levels can gift the money to a beneficiary and have the child open the account. The gifting process does give the child control of the money at age 18. Like an IRA, a contributor may fund the ESA through April 15th of the following year. Folks cannot contribute once the child reaches age 18. The account owner must liquidate the account or change the beneficiary before the currently designated one turns age 30.
Investments: Unlike 529 plans in which the plan sponsors pick the specific investment options. The firm (Bank or Brokerage) offering the account normally offers their full range of CDs, stocks, mutual funds and more. So for example in account opened at TD Ameritrade, the contributor would have the range of investments offered by TD Ameritrade. As a result of the age 18 limit, beneficiaries may receive a total of $34,000 if started before the first birthday. The relative small size of these accounts has caused some large firms such as Vanguard and Fidelity to not offer the accounts. Some institutions charge fees for ESAs to cover expenses. The ESA fees are more transparent than fees built in to other account types such as 529 plans. The most important investment consideration is the asset allocation held in the account. Specifically this means the types and percentages of particular investment classes held. It is common to think that younger folks have a great tolerance for investment risk. While this may be true for the kids’ retirement, money contributed for a ten year old maybe needed in just 8 years for college. An individual with near term spending need should use conservative investments. Just as one might expect a person near retirement to have a more conservative portfolio to safe guard the principal. A child with less than 15 years until planned use should have the ESA money in much less risky investments.
Education Money Use: Probably the most enticing idea of an ESA is it tax-free use of the earnings for schooling. The education expense rules for ESAs are the most liberal of all educations plans. First, they cover all the same expenses as 529 plans such as tuition, books, room and board (for more than halftime students), and special services. Second, ESAs can also make contributions to Qualified Tuition Programs such as 529 plans. Thirdly, the real gem is that the money can also be used for K-12 expenses required or provided by the school such tuition, fees, tutoring, uniforms, and more. The ESA account can also be used for computers and internet access. A parent can put aside money for a 2 year old to use for expenses needed later in grade school or high school. For higher income folks, the gifting process mentioned earlier can protect the income generated from taxation such as the Net Investment Tax and the child from Kiddie Tax exposure.
Using ESA for Money Education:
Here is where I see a great thou less tangible value in the ESA accounts. Using one of these accounts maybe ideal for a child to save for a portion of their college or high school expenses. When kid funded, ESAs offer exposure to and experience in saving for specific purposes, participating in the accounting opening process, making investment choices, and understanding the use of a tax favored account. This assumes the parent does this with the child in an age appropriate manner and not for the child.
Contributions. I believe that our kids should have some responsibilities with money as a way to learn about dealing with it. I would rather my son make learning mistakes with small amounts of money rather than large amounts later in life. Cash from gifts, allowance savings, household chores and outside jobs can be contributed by a child to account for their own benefit. The relatively small contribution limits make this account more accessible and realistic for a child to contribute.
College Use. Unlike some accounts, the child doesn’t gain full access for unlimited use when they become an adult. The IRS imposes tax and penalties for non-education use of the funds. The account’s relatively small maximum contribution size make them useful for, perhaps, one year of college education. I believe that kids should pay for or earn scholarships to cover at least 30% of their college education. ESA provides an account type for the child to hold their contribution of college funding outside of taxation.
K-12 Use. Perhaps a better use in some situations is for pre-college education expense. While the IRS imposes some specific spending guidelines they are rather liberal. It is possible to use the accounts for school activities or technology that a child desires rather than needs to have to graduate. What kid probably doesn’t wants a fancier computer/tablet or faster internet service? This is a way to fund it. Kids today do need access to the internet for educational purposes. Why not require a child to help pay for a premium level device or service from their self-funded tax-free ESA account? Establishing an ESA for such items can be a great teaching tool for saving and spending. If the child decides not to use the money in high school, the money remains available for college education.
Coverdell Educational Savings Accounts have limitations such as contribution size that frequently make them overlooked for college use. Using one of these accounts maybe ideal for child to save and fund a portion of their college or high school expenses. With an ESA, a proactive parent can provide a practical exercise in saving for a purpose and learning financial skills. In short, ESAs are an awesome way to help kids become financially savvy.
For additional ESA information check out the following links.
http://www.irs.gov/publications/p970/ch07.html#en_US_2013
http://www.savingforcollege.com/intro_to_esas/index.php?esa_faq_category_id=2
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