Coverdells and Custodial Accounts

People who want to save for a child’s college education have a wide array of choices.  Among these are Coverdell Education Saving Accounts (ESAs) and custodial brokerage accounts. Both options usually give you more investment choices than other college savings vehicles.

What Are ESAs?

Formerly known as Education IRAs, ESAs are another tax-advantaged way to pay for college. Unlike 529 plans, your investment options are virtually limitless. Except for investing in life insurance contracts, you can buy and sell what you want whenever you want. Also, you can set them up at almost any brokerage firm, mutual-fund company or other financial institution.

Federal Tax Advantages

As with 529 plans, contributions are not deductible, but earnings in ESAs are tax-deferred, and withdrawals that are used for qualified education expenses are tax-free.

Education Expenses Covered

One advantage that ESAs have over other tax-advantaged saving options is that you can make tax-free withdrawals to pay for private elementary and high school expenses, as well as post-secondary school expenses. So if a private school is in the future, one option you might want to consider is saving for that expense in an ESA and using a 529 plan for college.

Contribution Limits

ESAs have two annual contribution limits for individuals:

  1. You can give up to $2,000 to any one beneficiary assuming you meet the ESA income limits discussed below.
  2. The total of all contributions to all ESAs set up for one beneficiary cannot exceed $2,000. If other family members set up ESAs for your child, you need to check with them to make sure this contribution limit is not exceeded.

Invest $2,000 a year at an annual yield of 6 percent from the time your child is born, and you will have a little more than $61,000 in college savings when your child turns 18. Can't save that much, or think you can get a higher return on your investment? Use our College Savings Calculator to estimate your savings.

Filing status: You can make the
full $2,000
contribution if…
Your ESA
contribution will be
reduced if…
You cannot
make an ESA
contribution if…
Single Your modified adjusted gross income is $95,000 or less. Your modified adjusted gross income is between $95,001 and $110,000. Your modified adjusted gross income is more than $110,000.
Married filing jointly Your modified adjusted gross income is $190,000 or less. Your modified adjusted gross income is between $190,001 and $220,000. Your modified adjusted gross income is more than $220,000.
Figuring Your ESA Contribution Limit

If your Modified Adjusted Gross Income (MAGI) is between $190,000 and $220,000 (joint filers), or $95,000 and $110,000 (single filers), you can figure your ESA contribution limit by using the following equations:

Married Joint Filers

$2,000 – (MAGI – $190,000) x $2,000 = Contribution Limit
$30,000

Single Filers

$2,000 – (MAGI – $95,000) x $2,000 = Contribution Limit
$15,000

Organizations, such as corporations, can also contribute to ESAs and are not subject to any income limits. For more information, see IRS Publication 970.

Fees, Charges and Expenses

Fees, charges and expenses will vary depending on the investments you choose and the institution with which you open an ESA. Remember, however, that because of the fairly low contribution limits, even small annual fees or expenses could make a big difference in the value of your investment over time.

Custodial Accounts

Custodial accounts—Uniform Gift to Minors Act (UGMA) accounts or Uniform Transfer to Minors Act (UTMA) accounts—are another tax-advantaged way to save for college. A parent, grandparent or other adult is custodian for the account and makes all the investment decisions until the child for whom the account was opened reaches the age of majority. UGMA accounts are limited to money and securities. UTMA accounts can hold other types of property. You can set up these accounts at almost any brokerage firm, mutual fund company or other financial institution.

Advantages

In tax year 2015, for children younger than 19 or younger than 24 if a full-time student, the first $1,050 of unearned income is tax-free. The next $1,050 in unearned income is taxed at the child's federal tax rate, as is earned income over $1,050. Unearned income over $2,100 is taxed at the custodian's federal tax rate. To learn more about the tax rules for children, you should read IRS Publication 929: Tax Rules for Children and Dependents .

As with Education Savings Accounts, your investing options are virtually limitless. Nor are there any contribution or income limitations. In addition, withdrawals can be used for any purpose, not just qualified education expenses, without penalty.

Disadvantages

When your child reaches the age of majority—18 to 25 depending on the state in which you live—he or she takes control of the account and can use the money in the account for anything. Because you lose control over how the money may be spent, some parents and grandparents may not like this option. Another potential disadvantage is that because the account is considered the child's asset, it may have a bigger negative impact on future financial aid. Plus, you can't switch beneficiaries. If your child decides not go to college or gets a scholarship, you can't switch the money to a brother, sister or other family member.

Tax-Free Transfer to a 529 Plan. You now can transfer funds from a custodial account to a 529 plan if the plan accepts such transfers. However, you must liquidate any investments you have made in a custodial account, and you must also pay taxes on any gains you made on your investments.