The Coverdell ESA provides a very smart option to create a college savings account. The key benefit is that your savings are allowed to grow tax free and the money in the account can be withdrawn tax free if it is used to pay for educational expenses. Moreover, the Coverdell ESA allows you a lot more flexibility in managing your investments than the other major tax advantaged college savings account, 529s.
I’ve read quite a few online discussions regarding the Coverdell ESA, and I’ve noticed that there is quite a bit of misinformation out there regarding these accounts. Let me clear up a few things by referring to the official authority, the IRS. The IRS’s March 26 edition of Tax Tips provides a good summary of the key features of the Coverdell ESA, and it includes several links to more in depth information. Here are some highlights:
- Earnings on contributions will be distributed tax free, provided that they are used to pay the beneficiary’s school or college education expenses.
- Up to $2,000 may be contributed to a child’s Coverdell ESA each year (assuming your adjusted gross income is less than $95,000 for single taxpayers and $190,000 for married taxpayers).
- You can fund both a Coverdell ESA and a 529 account as long as you don’t exceed the annual gift tax exclusion per child (currently $13,000 or $26,000 for married couples, see IRS Publication 950).
Another good source of information on the Coverdell ESA is Savingforcollege.com. They provide a detailed list of the advantages and disadvantages of the Coverdell ESA.
I decided to open up my Coverdell ESA with Firstrade. There are not many options for opening up a Coverdell ESA with an online discount broker and many of the remaining options charge annual maintenance fees (a major drag on performance for a small account). Firstrade has no annual fees, no account establishment fees and low commissions. The only drawback is that they have a $50 out-going account transfer fee if you decide to move your money to another broker. I have a Roth IRA with Firstrade and I’ve been fairly pleased with their service so far. If you are interested in opening an account with Firstrade, I would be more than happy to send you a referral (Disclosure: I get some free trades for referrals).
Originally published on October 17, 2004. Updated to reflect current rules.