In my previous post, I have looked into Coverdell Education Savings Account and checked if it can be used by homeschoolers to pay for homeschooling expenses. The good thing it can be used as a savings vehicle and probably is the only viable option for homeschoolers. However, there is one catch. In order to qualify for the Coverdell, your state must treat homeschool as a private school. Unfortunately, at this moment not every state does that (in fact, only 14 out of 50 states treat homeschool as a private school), meaning that not every family can use it.
Anyways, even if your state does not allow to withdraw money to pay for your homeschool expenses, there are still a lot of ways to benefit from opening a Coverdell ESA. The most important one is that money grows tax-free and can be invested in almost any investment vehicle out there, including individual stocks, options, ETFs, mutual funds. The other important feature of the Coverdell is that it can be used not only for elementary and middle school expenses, but for college and personal education, too. Taking into account only these few factors, I highly encourage you to consider opening a Coverdell ESA as a tool for paying off your kids future education expenses.
How to open a Coverdell ESA?
Opening a Coverdell ESA is pretty similar to opening any other investment account, meaning it is usually done online by filling out a form. However, the challenge is to find a decent, low-cost provider. Not many financial institutions want to bother themselves with the Coverdell mostly due to low contribution limits and low profit potential. Those who do offer it usually charge high fees or have some other constraints. And this is something you should always keep in my mind.
You can open an account with any financial institution or custodian, like a bank, broker, or investment company. By opening an account with a bank, you basically deposit your money in a savings account where they grow risk-free until you withdrawing your money. However, under current low-interest rate environment pursuing this option does not provide you with any significant benefits. It will take you a decade to see a notable increase. As an alternative, you are better off by opening an account with a broker so you can get an access to a broader range of investment vehicles and create an investment portfolio aligned with you investment horizon and risk/return preferences.
Below you will find my list of best Coverdell ESA providers. In order to include a provider in the list, I looked at the following:
- Account minimum – $0, meaning you can start right away.
- Annual maintenance fees – $0, so you avoid paid high annual fees just for having the account.
- Transaction costs – since you will be contributing on a regular basis, you will need to invest your deposits and reinvest dividends. Paying too much in brokerage fees may significantly affect your investment return. My criteria were to find a provider that offers a wide variety of commission-free ETFs and/or has transaction costs as low as possible.
My Top Four Coverdell ESA Providers
- TD Ameritrade. TD Ameritrade is a well-known brokerage company that gives access to both individual stocks and exchange-traded funds. In general, its trading fees are very expensive, $9.99 per trade. However, my reason to include TDA in the list is that TDA offers a wide range of commission-free ETFs. 100 to be exact. The list of their ETFs allows investor to choose not only from domestic stocks and bonds, but also gain some exposure to international stocks and commodities. If you have your own model portfolio or work with an adviser who specializes in index funds then TDA may be a good option.
- TradeKing – is probably the cheapest online discount broker I was able to find that offers Coverdell ESA. For a flat $4.95 you will be able to trade individual stocks or ETFs of your choice.
- Capital One Sharebuilder – when Capital One bought ING Direct and ShareBuilder in 2012, I expected nothing good from the deal, especially fee-wise. Luckily, I was wrong. The company continued to provide excellent customer services, with not so high transaction costs as other big companies. Right now, you can trade for $6.95 per trade with no account minimums and maintenance fee.
- Firstrade – is not a broadly known online broker, but the one that offers competitive pricing. Right now it is $6.95 per trade with zero maintenance fee and account minimum.
If you look at the presented above options you may conclude that there is not a lot to choose from. And you will be absolutely correct. Even though there are some other brokerage companies on the market that you can choose from, I did not include them in the list because they either offer higher transaction fees or offer a poorer choice of commission-free ETFs.
I Choose TD Ameritrade
Whatever Coverdell ESA provider you decide to choose, you need to pay serious attention to trading costs, as they are one of the biggest threat towards accumulating enough funds to pay for your child’s education. Considering $2,000 annual contribution limit, actively trading on your account when you just start building your Coverdell ESA is definitely not an option. Trading fees will easily and quickly eat up all your potential profit or even worse, they may even dip into your principal. Moreover, even taking into account consistent $2,000 annual contribution for a total of $36,000 over the next 18 years (the age you are required by law to stop making further contributions), you will still may experience what a burden high transaction fees can be.
Having said that, I think that the best option with the Coverdell ESA is opening up an account with TD Ameritrade and creating a well-diversified index portfolio of commission-free ETFs, performing rebalancing on a regular basis, and reinvesting dividends along the way.
very useful info presented in a way easy to understand. you r a good person. thanks a lot.
is trading fee different from commission?
TD Ameritrade is a well-known brokerage company that gives access to both individual stocks and exchange-traded funds. In general, its trading fees are very expensive, $9.99 per trade. However, my reason to include TDA in the list is that TDA offers a wide range of commission-free ETFs. 100 to be exact.
Sharat,
Thank you for your kind words.
In general, a trading fee and a trading commission used interchangeably. However, they are not necessarily mean the same.
A broker usually charges a commission for each trade you place. If broker’s commission depends on the size of your transaction then it can be classified as a trading commission. However, if brokers commission is flat then it can be classified as a trading fee (i.e., $10 per each trade, no matter what is the size of the transaction). Also, a trading fee may include other costs (in addition to broker’s commission) that you incur during the trade, like exchange and clearing costs.
Good info. Thanks. Just what I was looking for.
Thanks, Heather!
any reason why schwab isn’t on the list? also only 6.95 per trade with some commission free EFTs
Hi Joseph,
I didn’t include them originally because they used to charge $8.95. They just dropped it two days ago to $6.95 which is now reasonable. Also, their free of charge ETF lineup has been significantly improved. So definitely worth making it to the list.
Thanks for the hint!
But TD has a better lineup?
Yes, in my opinion, TD’s lineup is better, especially for not very sophisticated investors. Better choice of index, low-cost ETFs.
Hi Vitaly
I don’t know if you know who Dave Ramsey is, but he recommends to invest first into ESA’s. However, he always recommends a good mutual fund, and doesn’t refer to ETF’s. Here’s a link to one of his published articles about ESA’s – but you can easily find others by him all with the same message. http://www.daveramsey.com/askdave/college/why-choose-the-esa – do you have an opinion about using an ESA with a mutual fund, not an ETF, and if you do, would you still recommend your 4 brokers in the same order you listed (where does Schwab come into your list? Many thanks
Hi John,
Schwab is definitely should be on the list and I will try to update it sooner rather than later. They dropped their commission to $6.95 which is now in line with other providers. Since the Coverdell allows for tax-free growth, there is no big difference in between mutual funds and ETFs.
However, I still believe that ETFs are better since they are more transparent, simpler, and give you more control over your portfolio. For example, you don’t have to analyze which share class is better (cheaper) and can buy/sell them at any time.
A good reason to consider opening up an account with Schwab is that they do allow Schwab ETFs commission-free trades. And Schwab has a few very good funds to choose from.
So before you make a decision on the provider, decide on your asset allocation first and then check each provider for they commission-free funds they offer. While you are just starting out the Coverdell, your goal should be to avoid any trading fees by all means.
Thanks.
Many thanks for your reply Vitaly
I want to establish accounts for my grandchildren. Who’s name should the account be opened under, the child, parent as custodian or the grandparents as custodian?
Hi Jay,
This is a very good question which isn’t easy to answer without knowing the whole picture. Even though you didn’t specify, I assume that you expect your grandchildren to apply for financial aid for college in the future. If yes, both a student and parents need to complete the FAFSA and/or the CSS Profile form. The CSS Profile is a more detailed form that analyzes student’s eligibility for college’s own aid funds. More colleges require filling out both forms.
Then, an expected family contribution (EFC) amount needs to be calculated. EFC is calculated using three different methods, all are based on student’s and parents income and assets.
Current legislation treats a student owned Coverdell ESA as an asset of the parent for federal aid purposes. What that means is that the account gets an asset protection allowance ($35,000) with up to 5.6% of the account value included in the EFC.
On the other hand, assets under a Coverdell ESA owned by a grandparent are not counted into the EFC calculation. However, distributions from the account to pay for the college are. These distributions can negatively affect the financial aid eligibility as they are required to be “added back” as an income when completing the new FAFSA form.
There are too many factors one need to consider before opening an education account. In most cases, it is better to open an education account under a parent name. However, in some cases, an education account opened under a grandparent’s name could be a decent alternative.
Do any coverdell providers allow option spread trading? I’ve found a number of them which allow options, but not specifically spread trades. From my understanding of the legislation any limited risk trading strategy should be permitted (think spread trading in IRAs), but I haven’t found any brokerages which permit it (due to their own more restrictive policiies) Any thoughts? Thank you!
Options express used to allow it. But now it’s been taken over by Schwab. Publish if you know of others.
Hi Vitaly,
Thank you for the great information. Is there anything you can roll into a Coverdell? For example 529, Roth IRA, or old 401K.
Hi Cherise,
This is a very good question and the answer is no to rollovers from Traditional 401(k)s and a 529 to a Coverdell. A 401(k) account and a Coverdell are taxed differently, so the IRS prohibits rolling over a 401(k) account to the Coverdell. 529 plans have much higher limits than a Coverdell, so you cant’t roll a 529 to a Coverdell. However, you can do the opposite and roll a Coverdell into a 529.
Regarding a Roth IRA you can simply withdraw your contributions (not earnings) at any time and then contribute to the Coverdell ESA.
Hope this helps. Please feel free to reach out if you have any questions.
Any recommendations for how I should figure out asset allocation for my 3 kids’ ESA’s (ages 12, 10, and 7)?
There is a ton of info out there for figuring it out for my retirement accounts, but I can’t seem to locate anything that helps me figure it out for my ESA’s. Thanks!
Hi Tedd,
Unlike a 529 plan where investment options are usually limited to certain mutual funds, a Coverdell ESA possesses one of the biggest advantages: flexibility. By that I mean that your funds can be invested in both traditional and alternative asset classes. This fact alone means that you can construct a better diversified, most likely cheaper, and if needed, more aggressive portfolio.
Unfortunately, there is no one-size-fits-all solution here and I certainly can’t recommend any asset allocation without having more information and understanding your situation and goals.
If you would like to discuss more privately, please feel free to send me an email or give a call. My contact info is here.
I’d be more than happy to learn more and help out.
Thanks