Q: We don’t have a lot of money, but we’d like to start a college savings plan for our 7½-year-old son. When he was born, we read a little about ESA plans, which we now understand are called Coverdell IRAs. We know one drawback of these is the $2,000 limit on the contributions you can deduct, but we can’t afford to save any more than that amount anyway. What do you think of these plans?
There is an annual limit of $2,000 per beneficiary that can be contributed to what’s now called a Coverdell Education Savings Account. The IRA may have been dropped from the name. It was misleading, since there is no tax deduction for contributions. The ability to contribute to a Coverdell is phased out for modified adjusted gross income (AGI) of $190,000 to $220,000 if you are married and file jointly and $95,000 to $110,000 if you are single. The maximum contribution of $2,000 is gradually reduced if your income is between the phase-out limits, and no contribution is permitted if your modified AGI is above the upper phase-out limit. Anyone can make the contribution as long as the $2,000 per beneficiary is not exceeded. If your income level is too high but your child’s grandparents qualify, they could make the contribution. If they cannot afford or are not inclined to use their money to fund your children’s education, you could gift them the money with the understanding that they will use it to make the Coverdell contributions.
Funds in a Coverdell must be used for the child’s qualified education needs. Qualified education expenses include elementary and secondary education expenses as well as higher education expenses. Coverdell funds can be used for a wide variety of education expenses, including: tuition, fees, books, supplies, equipment, academic tutoring, the purchase of computer technology or equipment (even internet access), room and board, uniforms, transportation and supplementary items such as extended day programs as required or provided by the school.
Contributions are nondeductible, growth on the money is tax-free, and Coverdell withdrawals are tax-free up to the beneficiary’s qualified expenses. Any amounts over that will be included in income for the beneficiary and subject to a 10 percent penalty. Any balance left must be distributed within 30 days after a beneficiary reaches age 30. The beneficiary is then taxed on the earnings portion of the distribution. If you are planning on federal financial aid, the Coverdell can be a disadvantage. The account is considered an asset of the student, not the parent. Before you fund a Coverdell; consider funding a Roth IRA or a 529 plan. Brief explanations of these follow.
You can contribute up to $5,500 ($6,500 if age 50 or over) to a Roth IRA. The ability to contribute to a Roth IRA is phased out for modified adjusted gross income (AGI) of $178,000 to $189,000 if you are married and file jointly and $112,000 to $127,000 if you are single. The maximum contribution is gradually reduced if your income is between the phase-out limits, and no contribution is permitted if your modified AGI is above the upper phase-out limit. Contributions are not tax-deductible, but the investments grow tax deferred and are tax free when taken out at age 59 ½ or after. Your contributions can be taken out at any age without a 10 percent early withdrawal penalty or income tax. If needed, you could use your contributions for your son’s education. If not needed, you are that much more prepared for retirement. The Roth IRA funds will not impact your ability to receive financial aid.
The 529 plan doesn’t have any income limitations; you can contribute to these plans regardless of your income level. The amounts you can contribute vary by state, but they are very high. Withdrawals are tax-free if used for qualified education expenses for students in a post secondary degree program. The 529 qualified expenses are limited to tuition, fees, books, supplies, equipment and room and board. Distributions not used for qualified higher education expenses are subject to income tax and a 10 percent penalty. Currently, assets in a 529 plan are considered assets of the parent for financial aid purposes.
A one hour meeting with a fee-only financial planner should be worth the cost.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624