Money Matters

Money Matters: Coverdell account offers alternative to 529 college savings plan

CorrespondentJanuary 25, 2014 

Q. We have an NC 529 plan for each of our children and have read about another plan for education, but we can’t find much information on it. It’s an IRA, but it can be used for education. Could you explain this IRA and why it may or may not be better than the 529 plan? We are disappointed that North Carolina eliminated the tax deduction for 529 contributions, and we are looking for alternative education savings vehicles.

A. The elimination of the state income tax deduction is a disappointment, especially when three states increased the income tax deduction for residents contributing to their state’s 529 plan, and at least five states offer a tax deduction for contributions to any 529 plan. It is still a good low-cost plan and one of the best ways to save for college.

The American Taxpayer Relief Act brought back Coverdell education savings accounts. There is more flexibility as to what the funds in ESAs can be used for, but the funding limits are much less than with 529 plans. Your child has to be under 18 years old for you to contribute to an ESA. There is an annual limit of $2,000 per beneficiary that can be contributed. The ability to contribute to a Coverdell is phased out for modified adjusted gross income 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, you could gift money to someone in a lower tax bracket, and they could make the ESA contribution for your children. If you fund an ESA, you need to make everyone that you think may be saving for your children’s education aware that the ESA is already funded. If the ESA is overfunded (more than $2,000 per child per year) the contribution limit has been breached, and a 6 percent excise tax will be owed on the excess. You have until May 31 of the following year to take it back out and avoid penalty.

Some ESAs will require that the responsible individual is a parent or legal guardian, so you can at least notice whether an excess contribution is made to the ESA by a grandparent or other friend/relative. If you are divorced, though, your ex-spouse could establish their own ESA; another great opportunity to talk with your ex!

Funds in a Coverdell must be used for a child’s qualified elementary, secondary or higher education needs. Qualified education expenses include 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 withdrawn for noneducational expenses will be included in income for the beneficiary and subject to a 10 percent penalty. Any balance left in an ESA 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.

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

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