Coverdell accounts, and choosing between education accounts

The account with three numbers attached to it

A Coverdell education savings account is a trust or custodial account opened for one beneficiary to pay for education. Contributions are made in cash and are not deductible for federal income tax, which it has in common with a 529 plan and with a Roth account: the tax break comes at the other end, when a qualified withdrawal is not taxed at all.

What sets a Coverdell apart is that three numbers govern it, and the exam asks about all three. Total contributions for one beneficiary may not exceed $2,000 in a year, however many people contribute and however many accounts exist. No contribution may be accepted after the beneficiary reaches 18, except for a special-needs beneficiary. And any balance still there when the beneficiary reaches 30 must be distributed within 30 days. A beneficiary with special needs is outside the two age rules.

A withdrawal spent on qualified education expenses is tax free, and those expenses include elementary and secondary schooling as well as college. A withdrawal that is not spent that way is treated less kindly: the earnings portion is included in income and generally an additional tax of 10 percent applies to that taxable earnings amount. Exceptions to the additional tax exist. The contributions themselves come back untaxed, because they were never deducted.

Set that against a 529 plan. A 529 has no annual federal contribution ceiling of the Coverdell kind and no matching age-18 or age-30 rule. Large contributions can raise federal gift-tax questions, and a special election lets a contributor spread one over five years. It is generous in a different way and restricted in one: for elementary and secondary expenses, the distributions treated as qualified are capped at $20,000 a year for a beneficiary, a figure that replaced $10,000 for tax years beginning after 2025. If a distribution exceeds qualified expenses, its taxable earnings generally carry the 10 percent additional tax unless an exception applies.

A family can use both accounts for the same beneficiary. For example, an eligible family saving $6,000 could contribute $2,000 to a Coverdell and $4,000 to a 529, subject to each account’s rules. A beneficiary age 19 without special needs cannot receive new Coverdell contributions, but a 529 may still be used. Compare eligible expenses, investments and fees before choosing.

Exam terms

Coverdell education savings account

An education account for one beneficiary, capped at $2,000 of contributions a year.

Qualified education expenses

Spending the account can cover tax free, including elementary and secondary schooling.

Age 18

The contribution cutoff, except for a special-needs beneficiary.

Age 30

The distribution age, with 30 days to distribute and a special-needs exception.

10 percent additional tax

Generally applies to taxable earnings from a nonqualified withdrawal; statutory exceptions exist.

Worked example

Grandparents want to put $3,000 a year into a Coverdell for a grandchild, and each of two aunts wants to add $1,000 to accounts of their own for the same child.

1. The $2,000 ceiling belongs to the beneficiary, not to the contributor and not to the account, so the three of them are sharing one allowance.
2. Between them they are proposing $5,000, which is $3,000 more than may be contributed for that child in the year.
3. Opening extra accounts changes nothing at all; the aggregate for the beneficiary is what the rule measures.
4. If the child is already 18 and has no special needs, no new Coverdell contribution may be accepted.
5. At age 30, a beneficiary without special needs must receive the balance within 30 days. A nonqualified distribution generally has taxable earnings and a 10 percent additional tax unless an exception applies.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• 529 contribution and withdrawal tax treatmentPractice this