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Tax-Advantaged Accounts

Investor Insights Blog|Coverdell Education Savings Account Rules

Tax-Advantaged Accounts

Coverdell Education Savings Account Rules

A Coverdell Education Savings Account (CESA) is a special account that can be used to save, invest and pay for a child’s education with tax advantages.

Contributions to a CESA are not tax deductible, but distributions are tax-free if used for qualified education expenses at an eligible institution. You also don’t pay taxes on income or capital gains when you invest with a CESA, allowing your returns to compound faster.

Who is eligible for a CESA?

A CESA can be opened for a beneficiary under the age of 18 or for someone with special needs. A parent, grandparent or other relative can open this education savings account and designate the beneficiary.
It’s even possible to open a CESA in addition to a 529 plan or other education savings account.

Once opened, anyone is able to contribute to a CESA: including the beneficiary, parents, grandparents, relatives and even corporations or other organizations. However, there are some limitations related to who can contribute and how much.

CESA Contribution Limits

For 2020, the maximum contribution to a CESA is $2,000. The contribution limits set by the IRS each year are per beneficiary, even if more than one CESA is established for the same child.

Contributions can’t be made after the beneficiary reaches age 18, unless they are a special needs beneficiary. Although you can no longer contribute to a CESA after the beneficiary reaches 18, you can continue to maintain, invest and use funds from the account until the beneficiary reaches age 30.

CESA Income Limits

There are also income limitations for who can contribute or deposit funds into the account, although they don’t apply to organizations such as corporations or trusts.

In 2020, you are able to make a full contribution if your modified adjusted gross income (MAGI) is less than $95,000 (single filer) or less than $190,000 if married filing jointly. From there the amount you can contribute begins to reduce until you are no longer able to contribute with a MAGI of $110,000 or more (single) or $220,000 or more (married filing jointly).

However, unlike other savings plans that require earned income, you don’t need earned income to contribute to a CESA. It may be possible for a child or other individual to contribute to a CESA, even if the parents or person who established the account exceeds the contribution income limitations.

Coverdell Education Savings Account Withdrawal Rules

Distributions or withdrawals from a CESA are generally tax-free if used for qualified education expenses related to the beneficiary’s enrollment or attendance at an eligible institution. Check out this blog for a list of qualified education expenses and eligible institutions.

CESA withdrawals may also be impacted by other tax-free educational assistance such as scholarships or grants. IRS Publication 970, Chapter 7 outlines how to calculate the beneficiary’s adjusted qualified education expenses to determine if the distributions are tax-free.

A portion of distributions may generally be taxable if the total distributions are more than the beneficiary’s adjusted qualified education expenses for the year or if used for something other than qualified education expenses. Aside from certain exceptions outlined in IRS Publication 970, a 10-percent penalty is also applied to the amount of taxable distributions included in income.

The full account must be distributed when the beneficiary reaches age 30 unless they are a special needs beneficiary. These distributions are also generally included in taxable income with the 10-percent penalty when distributed at age 30.

However, it may be possible to change the account’s beneficiary to a qualifying family member under age 30 or to transfer or rollover the funds to another beneficiary’s account.

Where can you open a Coverdell Education Savings Account?

A CESA must be opened with a trustee, custodian or other entity approved by the IRS. You can open an education savings account at Equity Trust and with most retirement custodians, banks, brokerages or other financial institutions.

However, it’s important to do your research because where you open your CESA may determine your investment options.

Education Savings Account Investment Options

Although CESAs only allow up to a $2,000 contribution each year, it’s possible to grow the account over time by investing in a tax-free environment. The earlier a CESA can be established for a beneficiary, the longer you have an opportunity to benefit from tax-free compounding interest.

Most companies limit your CESA investment options to traditional assets like stocks, bonds and mutual funds. With a self-directed CESA at Equity Trust, you have the freedom and flexibility to invest in traditional assets, plus a wide variety of alternative assets as well.

CESAs at Equity Trust can invest in real estate, mortgage notes, private lending, private equity, tax liens and many other types of alternative investments.

To learn more about how a self-directed CESA at Equity Trust could help you save, invest and pay for a child’s education with tax advantages, download our free CESA Guide or call 855-673-4721 to speak with a Senior Account

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