Category Archives: Coverdell ESA

Education Tax Credits

If your income is less than $180,000 (married filer) or $90,000 (single), you may be eligible for the American Opportunity Tax Credit while your student is in college. This is a credit of up to $2,500 annually, so nothing to sneeze at. Here’s the catch: You can only take the credit for expenses for which you did not use another tax benefit (i.e., for expenses paid Continue reading Education Tax Credits

Obama’s Proposed Changes to 529 Plans

Part of President Obama’s proposal to “simplify the tax code” includes significant changes to the tax treatment of 529 plans and Coverdell ESA accounts: for new contributions (i.e, after enactment of this proposal, should that happen) distributions would no longer be tax-free, even if they are used for qualified education expenses. The proposal doesn’t just remove benefits; it also expands the American Opportunity Tax Credit and eliminates the tax on student loan debt forgiveness under certain income-based repayment programs.

The logic behind the proposal is this: Improving the education tax credits (which are scheduled to expire in 2017 under current law) increases the benefit to students from middle-income families, given the income caps in place. 529 plans and Coverdell ESAs disproportionately benefit students from wealthy families, since 70% of assets in the plans are held by families with incomes above $200,000, per the Federal Reserve. In addition, the increased tax revenue from plan withdrawals would help fund the President’s proposal to provide two years of community college free.

Before you start to yell and scream that this is extremely unfair, a couple of things:

  • Read’s article on the many reasons that this proposal is highly unlikely to be enacted.
  • Remember that this would only apply to new contributions to these plans, after the proposal is enacted. If that isn’t a good reason to up your plan contributions sooner rather than later, I don’t know what is.

Matching 529 distributions to qualified expenses

So Junior is off to college and now it’s time to start paying the bills. For those who have done a good job putting money away in a 529 account, it’s important that you time your distributions in the same year as your expenses. It’s time to learn about two forms: the 1099-Q and the 1098-T.

The 1099-Q reports your withdrawals from a qualified tuition program such as a 529 or Coverdell ESA in a calendar year. The 1099-Q goes to the person who received the withdrawals. So if the withdrawal went to you, the parent, then you will receive the 1099-Q. If the withdrawal went to the student, then the student will receive the 1099-Q. (See my previous post about why you would want withdrawals going to either the student or parent.)

The 1098-T is provided by the college and details qualified tuition and related expenses for the year. The 1098-T is issued to the student, regardless of who pays the tuition. Check with your school to see what exactly is on the 1098-T. Typically room and board expenses, even if paid to the school, are not, though those are qualified higher education expenses.

IMPORTANT: The 1098-T can show either amounts billed or amounts paid. If the amount is in Box 1, then it’s the amount paid. If it’s in Box 2, it’s the amount billed. Your distributions can only be used for amounts paid. So if you receive a bill in December that is due in January, wait until January to take the distribution from your 529 account. If your withdrawals exceed your expenses paid, then you’ll be subject to tax and the 10% penalty.

Many schools offer the opportunity to prepay all four years of tuition in order to lock in current rates. This can be a good deal, but beware the consequences of withdrawing the full amount from your 529 plan. Most schools still only credit you each year’s tuition expense annually, even if you prepay. If that is the case, then you need to come up with other money to prepay the tuition and then reimburse yourself annually from the 529 plan. Otherwise, you might pay  a 10% penalty to achieve a 7% savings. Check with your school if they make this offer.

And don’t forget, you can’t double-dip on tax benefits. What that means is, if you plan to take the American Opportunity or Hope tax credit, you need to pay some of your qualifying expenses with cash flow, not 529 plans. You can’t use tax-advantaged funds to pay for something and then also take a tax deduction for the payment. Here is more info on the AOTC and Hope tax credits.

Coverdell ESAs

Given the lower contribution limit—$2000 annually per beneficiary—many people wonder why anyone would bother with a Coverdell ESA, compared with a 529 plan. Here’s a quick overview; maybe you’ll find that a Coverdell ESA should be part of your college savings planning as well.

Coverdell ESAs work a lot like Roth IRAs and 529 plans: You contribute after-tax money to them, and future withdrawals are tax-free. Like 529 plan withdrawals, Coverdell ESA withdrawals are not counted as income in aid formulas. So, what’s different? Several things:

  • Qualifying expenses: Funds in Coverdell ESAs can be used for K-12 expenses, in addition to college expenses. For K-12 expenses, a qualifying school is any elementary or secondary school as defined under applicable state laws—which may include home schooling. If you have a child in private school, or intend to send one to private school, a Coverdell ESA can be a big help. Likewise if you intend to home school, you may be able to use a Coverdell ESA to cover some of the costs you incur.
  • Investment choices: Coverdell ESAs are self-directed investments. That means you open the account and you choose the investments. Many custodians, including Schwab, USAA, State Street Bank, Scottrade, TD Ameritrade, Capital One and more, offer low-cost Coverdell ESAs.
  • Income limits: Joint filers need MAGI below $190,000 in order to contribute to a Coverdell ESA. If your income is above that threshold, you can gift money to your child who can then open the account.
  • Beneficiary changes: Coverdell ESAs let you change the beneficiary to any other family member who is under age 30.


Donors and custodians may impose restrictions or rules so if you think a Coverdell ESA might be a good fit for your family, be sure to read all the fine print before investing.