In my previous post, I analyzed the benefits of a Coverdell Education Savings Account and found out that it is a very powerful vehicle, despite its low $2,000 annual contribution limit. It can be used not only for elementary, middle or higher education, but for homeschooling as well, which makes it unique. In addition, the Coverdell ESA gives more flexibility in terms of investment choices, allowing you to invest almost in all stocks, bonds, and funds out there on the market. [Read more…] about A 529 Plan: A Good Vehicle For College Savings
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.
We all wish our children only the best. How could it be any other way! Toys, clothes, summer camps, trips to Disneyland… I can go on and go on. But since the first day of the child’s life, there is something that is always on the mind and gives no peace. It is EDUCATION.
College prices continue to rise. In 2014, private colleges tuition and fees increased by a whopping 3.7%, to $31,231 per year. That is 2.3 percentage points above the level of inflation through September 2014. No wonder why many parents ring the alarm. The “good news” is that the pace of increase slowed down and stopped accelerating.
A client of mine, who has three beautiful kids, recently asked me which options he has in order to save and pay for his children’s education. More specifically, he was interested in elementary and secondary education first, leaving a discussion about higher education for the next time. In addition, being a homeschooler in the past and an avid traveler, he was wondering if there are any options that would allow him to pay for home school education expenses, as well as for international educational historic trips, for instance to Italy, France, or wherever he wants to take them.
Let’s address his questions in order.
Right now, there are two main education savings vehicles: Coverdell Education Savings Account (ESA) and 529 plan. A 529 plan is a plan that can be used for higher education only. Because my client is interested in elementary and secondary education for his kids, I will leave it out. However, a 529 plan is a very effective instrument in getting your kids ready for college and I will cover it in my future post.
The only viable option we are left is a Coverdell ESA. Let me briefly describe what that is.
What is a Coverdell ESA?
Previously known as an Education IRA, in 2002, it was renamed to Coverdell Education Savings Account, named after the Senator Paul Coverdell. A Coverdell ESA is a trust created for the purpose of paying the qualified education expenses. Coverdell accounts are exempt from federal taxes and designed to encourage savings to pay future education expenses.
Why Would You Want To Consider Coverdell?
- Money in the account grows tax-free with the proceeds allowed to be withdrawn tax-free only for qualified education expenses.
- More investment options and flexibility (compared to 529). Money is invested in a tax-free brokerage account that allows an owner to allocate funds between individual stocks, bonds, ETFs, or mutual funds. The only limitation is that the money cannot be invested in life insurance contracts.
- Account may be rolled over to another family member if his age remains below 30, in order to avoid taxes and penalties. Another useful option you may consider is rolling over your Coverdell into a 529 plan.
- Money is allowed to be withdrawn not only on qualified higher education expenses, but on elementary and secondary school expenses as well, including homeschool expenses my client is concerned with. Some of the qualified expenses include books, supplies, computers, Internet access and many other. For more on qualified expenses, please see visit this link.
- If you consider applying for financial aid, then money in the Coverdell account is considered as parental assets, not child’s, even if the owner of the account is the child. Qualified withdrawals are not reported as student or parent income.
- You can contribute to both Coverdell and 529 for the same beneficiary.
Maximum contribution limit is $2,000 per year per beneficiary. For some people it may be too small, but do not disregard it that fast. It still has some valuable features. From a tax standpoint, your contribution is treated as a gift from you to your child and qualifies for an annual $14,000 gift tax exclusion. Once you made a gift, your gift is irreversible and cannot be undone.
To be able to contribute towards Coverdell, you modified adjusted gross income must not exceed the following limits (for 2015):
Single (Married couples filing jointly) income tax filers:
- Under $95,000 ($190,000) – full contribution
- Between $95,000 – $110,000 ($190,000 – $220,000 – partial contribution
- Above $110,000 ($220,000) – no contribution is allowed
If your income exceeds the above limits, contribution can be made by grandparents or other family members. Alternatively, a child can contribute on his own behalf (by making a gift to the child, like a transfer to a custodian account under the Uniform Transfers Minors Act.)
In addition to income limits, there are two age limits that you should be aware of. First age limit is 18. Once the beneficiary reaches this age, no contributions can be made. Second age limit is 30. After the beneficiary turns age 30, the account must be disbursed on qualified education expenses within 30 days. If the money is not fully withdrawn, further account growth becomes taxable as ordinary income and subject to the additional 10% penalty tax.
You are allowed to contribute towards a Coverdell ESA only after-tax dollars, meaning no tax deductions that you are so accustomed to when making IRA contributions. All contributions should be made in cash only. In addition, trusts and corporations may contribute to Coverdell account. There is no income limitation for contributions by trusts or corporations. Therefore, if you have a trust or own a corporation, you can use this option to avoid the income limitation.
You can open as many Coverdell accounts as you wish. However, it usually doesn’t make much sense, taking into account fees and imposed custodian minimums.
Things to Avoid
- Do not contribute more than $2,000 per year. Otherwise, you will have to pay 6% tax penalty. I would recommend coordinating contributions with other family members, especially with child’s grandparents. Grandparents are usually so generous that they contribute over the limit. Check your form 5498 to find out the exact contributed amount.
- Make sure that your child withdraws from the account no more than the actual amount of qualified education expenses incurred in the period. If your child withdraws more than the actual amount of expenses, then be ready to pay income tax and 10% penalty on the earnings portion of the amount above the actual expenses.
As you can see, Coverdell ESA offers many benefits, despite low contribution limits. It is tax-efficient, money grows tax free, funds can be rolled over among family members and spent on elementary and secondary education, in addition to higher education.
In my future posts, I will explain how one can establish a Coverdell ESA and offer a list of providers. As for now, let’s get back to the above questions.
Can I Use Coverdell for Homeschooling?
The answer is ‘yes’, but there are some catches and it depends on the state you live in. In order for home education expenses to qualify for Coverdell ESA, your state must treat homeschooling as a private school. Illinois, where my client resides, treats homeschool as a private school, meaning he can utilize the Coverdell ESA and pay for qualified education expenses.
As of now, only 14 states treat homeschools as private schools, while the remaining 36 states do not, which means homeschoolers cannot use Coverdell (except for college). If you consider homeschooling for your children, I highly recommend checking your state laws before establishing a Coverdell ESA.
Another advantage for my client in using Coverdell for home education is the ability to take tax credit on his state income tax. Currently, there are only three states the allow homeschoolers to take a credit: Illinois, Louisiana, and Minnesota. Illinois allows homeschoolers to take a credit of 25% of a student’s qualified education expenses after the first $250. The maximum credit is $500. Honestly, I was pleasantly surprised to see Illinois in the list. Considering Illinois high sales and property taxes, this small tax break definitely does not hurt, especially low-income families.
Can You Use Coverdell to Pay for International Educational Historic Trips?
Unfortunately, no! The law clearly states use for “qualified education expenses only” and traveling, even for educational purposes, is not one of them. What a pity! I think most kids would be in the seventh heaven to study history and geography that way.