First, what I’m about to say may fly in the face of what you’ve heard from your tax professional or financial advisor: The Coverdell ESA is by far the best tool to save and build wealth for college expenses tax-free. The Coverdell is superior to the 529 Plans hands down and employs a secret weapon that can build a nest egg for college faster than any other tax-preferred method in the United States.
Thus, I refer to this type of special type of structure as the “hidden gem” in the financial marketplace of planning. And yes, I realize that this is a bold statement, but I will back it up clearly and distinctly here in this article.
What’s with the Name?
The name “Coverdell ESA” can be confusing as this tax-preferred structure has been referred to various names in the past. Since originally passed in 1997 it has been referred to as an Education Savings Account, a Coverdell account, and formerly known as an Educational IRA. The account is named for its primary champion in the U.S. Senate, Senator Paul Coverdell, a Republican from the State of Georgia.
The bottom line is, there is only one account such as this used in the U.S. today and it’s known as the Coverdell ESA (Education Savings Account). It has one important purpose and one purpose only: to build money tax-free for educational expenses with investments you control!
How does the Coverdell Education Account work?
Think of a Coverdell ESA as simply an IRA (hence, why it was previously referred to as a type of Educational IRA). Thus, like a Roth IRA or Health Savings Account any investments inside the ESA will grow tax-free, and come out tax-free, but only for any qualified education expense. These distributions would even include qualified elementary and secondary school expenses- Not just college expenses. (More below).
There are 3 key people to keep in mind in the construct of the ESA
- Beneficiary. Must be under age 18 when the account is established and typically a child or grandchild for whose benefit the account is established.
- Responsible Party. This is the person that decides where the account is invested when to make valid distributions for educational expenses, and if the Beneficiary doesn’t use all the money by age 30, the Responsible Individual can change the Beneficiary to a different family member.
- Donor/Contributor. This is the person, which doesn’t even have to be a family member, that makes the contribution to the Coverdell ESA in any given year under the applicable rules.
And yes, there is no state or federal tax deduction to ‘contribute’ to the ESA, which is certainly a drawback compared to the 529. However, the non-deductibility is not fatal to the overall strategy and I don’t consider it an issue when looking at the big picture. The main reason being that the deduction for a 529 Plan contribution is very limited in its amount, can only be taken in certain states where the donor is a resident of the same State where the Plan is established, and there isn’t even a Federal tax deduction for the 529 Plan or Coverdell ESA.
Contributions on behalf of a Beneficiary
The maximum contribution in 2021 to a Coverdell ESA is $2,000 per Beneficiary, and even if a Beneficiary has multiple ESA accounts, the total contribution is still limited to $2,000 amongst all accounts (Keep in mind and don’t fret…the contribution limit is not a drawback as I will explain further below).
Contributions can be made up until April 15th for the prior year. In 2021, due to the Covid pandemic, contributions can be made up until May 17, 2021, for the 2020 tax year.
As I stated above, the Beneficiary must be under age 18 when the Coverdell ESA is opened on their behalf and the contributions of $2,000 a year can only be made up until the date of their 18th birthday (not the year they turn 18).
Example – So if your child is 12 years old, it’s currently May 1, 2021 and their birthday is on July 15th, you would be able to contribute $ between now and their 18th birthday. ($2,000 for 2020 before May 17th, $2,000 for X more years, and $2,000 in 202X before July 15th and their 18th birthday. That may not sound like a lot with the current cost of a college education, but wait until I discuss the Secret Weapon within the ESA below.
Who may be the Grantor or Depositor
It’s important to understand who qualifies to actually make a ‘contribution’ into an ESA for a Beneficiary because there are income limits on who the Depositor can be. Proponents of the 529 Plan like to also harp on the ESA contribution limit, and but again I consider it a non-issue. Over the years when necessary for a client, we employ a simple ‘work around’ or ‘back door’ method in order to make contributions.
Now the current ‘front door’ rule in 2021 is that no one with more than $110,000 (single) or $220,000 (married filing joint) of Adjusted Gross Income, can make a contribution to an ESA on someone’s behalf. However, don’t forget the ‘back door’!
First, keep in mind that the person ‘establishing’ or ‘opening’ the ESA, doesn’t have to be the Depositor. Typically, we see the Responsible Individual (see below) create the ESA for a Beneficiary and then consider next who the Depositor will be.
Depositors into an ESA could be any of the following:
- Mom or Dad
- Grandma or Grandpa
- Aunt or Uncle
- Even the Beneficiary of the ESA themselves
- In fact anyone! They don’t even have to be family. Just someone that wants to help the Beneficiary save for college.
It’s also important to note the Depositor doesn’t have to have earned income or a minimum level of income either to make a contribution. But again, there IS a maximum income limit and caveat that they can’t have an overall AGI of over $110,000 (Single) or $220,000 (filing joint).
Thus, the ‘back door’ method is simply for Mom and/or Dad to gift money to a family member if necessary (under applicable gifting rules and limits of course), and the recipient of the gift makes the deposit into the ESA on behalf of the Beneficiary. Simple, straightforward, allowed, and nothing wrong with that!
The Control of the Responsible Individual
This is a wonderful feature of the Coverdell ESA because the Responsible Individual can be involved in the ESA right from the beginning and help make it happen at the forefront and carry it ultimately across the finish line when all the funds are distributed.
In practicality, the Responsible Individual is typically the one that ‘opens’ the ESA and coordinates the contribution, EVEN IF they aren’t the Donor to the ESA themselves due to an income limitation (see below).
Most importantly, the Responsible Individual can change the named ‘Beneficiary’ at any time! The only caveat is that the ‘roll-over’ or ‘transfer’ to a new beneficiary must be a qualified family member ‘in relationship to the original Beneficiary’, NOT the Responsible Individual OR the Donor/Contributor. To comply with the beneficiary change rules, the new beneficiary must be under age 30 and one of the following family members in relation to the current Beneficiary of the ESA before the change:
- Child or descendent of child, stepchild, or eligible foster child
- Brother, sister, stepbrother, or stepsister
- Father, mother, stepfather, or stepmother
- Aunt or uncle Niece or nephew
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- Spouse of any person described above
- First cousin
Important Note- When the Coverdell ESA is established, make sure on the formation documents to indicate that the Responsible Party will continue in this role after any Beneficiary turns 18. IF this election isn’t made, then the Beneficiary will assume control of the Coverdell at age 18 and can make any decisions they want regarding investments or distributions (essentially giving them unfettered access to the ‘cookie jar’).
The Responsible Individual not only gets to control the investments of the account, but can also decide when to distribute funds for a valid expense. Let’s get real…we don’t want the Beneficiary to have access to the ‘cookie jar’ without oversite.
The Secret Weapon inside the ESA. The little-known fact that can transform your Coverdell ESA into a powerhouse for college savings is the fact you can self-direct the investments. Proponents of the 529 Plan rarely acknowledge this, let alone mention it.
This is significant, if not life-changing because the average 529 ROR (Rate of Return) is well below 10% (on an annualized basis after expenses- essentially what really matters), while the Coverdell rate of return can be unlimited, with lower costs, and far more control.
For example, just this last year if you would have invested your $2,000 Coverdell ESA, on May 1, 2020 in the Cryptocurrency Ripple- XRP, it’s value today on April 29, 2021 would be approximately $180,797 (a 9,039% Rate of Return)! Are you kidding me?! Yes Cryptocurreny is clearly a risky investment, but this example simply shows the possiblities of
Investing in a cryptocurrency, a private company, gold, or individual stocks is literally IMPOSSIBLE in a 529 Plan. The ESA can even use non-recourse debt, or leverage, to even make small investments that can pay out enormous returns and in turn accelerate your college savings account very quickly. You will never get an annual return of over 10% in a 529, even if you’re lucky!
What are Qualified Education Expenses? Essentially, this term means tuition, fees, books, supplies, and equipment required for study at any accredited college, university, or vocational school in the United States and at some foreign universities. However, the money can also be used for room and board, as long as the fund beneficiary is at least a half-time student.
Off-campus housing costs are covered up to the allowance for room and board that the college includes in its cost of attendance for federal financial-aid purposes.
Beneficiaries may even withdraw the money tax-free for qualified elementary and secondary school expenses- Not just college expenses. This means you can pull money out tax-free for private elementary, middle, or high school.
Why isn’t Wall Street on Board with the Coverdell?
One simple reason: Wall Street makes more money with 529 plans, has more control of YOUR money, and can charge excessive fees (compared to self-directing an ESA). I seriously can’t calculate the amount of time I’ve wasted trying to literally find the actual Rate of Return (ROR) on any 529 Plan, AFTER expenses, set forth in a simple, straightforward manner, front and center on a 529 Plan’s website
Promoters or advocates of the 529, essentially Wall Street banks, Brokerages, and Mutual Fund Managers, will load up their websites with performance rankings with other plans, how great their diversified plans are (when they offer only one mutual fund managing the plan), how their expense ratios relate to other plans, and ALL of this without disclosing an actual annualized rate of return after expenses. The only way I’ve found to get to this ugly truth is to decipher a one-inch thick prospectus and spend hours diving into the detailed reports of any given 529 Plan. If anyone reading this article has access to a web page simply summarizing the actual rates of return on 529 Plans across the country, I would truly welcome it and link it here to this article.
Educational Savings Strategy on Steroids!
Yes…it gets better!! (a small ShamWow reference) This ‘next level’ strategy that I’ve seen implemented countless times, and even use in my own personal business structure and portfolio, is to combine the ESA and Roth accounts of family members in a non-prohibited LLC to invest with a larger pool of assets. This is a complex strategy and recommendation, which will certainly involve a consultation with one of our accountants or tax attorneys. If you are interested in learning about this concept of self-directing ANY of your retirement accounts including your Coverdell ESA, please watch our “6th Semi-Annual Self-Directed IRA Summit” held just this past month in April of 2021.
This strategy would take Moreover, it would take several pages to explain in detail, so I will simply explain it here in the form of “steps” and a sentence or two of explanation with each step.
- Step 1. Create a Coverdell ESA for each of your children, grandchildren, or nieces and nephews (the Beneficiaries). Make yourself the “Responsible Individual” and elect to continue serving as the Responsible Individual once they turn 18,
- Step 2. Have a person that falls within the income limitation fund each of these accounts. Use a “backdoor method” to contribute to the beneficiary’s account if the Responsible Individual has too high of an income.
- Step 3. Contribute $2,000 to each account for 2020 and 2021. Each beneficiary can only have $2,000 contributed to an ESA on their behalf, no matter how many accounts. Also, you have until May 17th, 2021 to make a contribution for 2020, and up until April 15th, 2022, to make a contribution to a beneficiary’s account for 2021. Hypothetically, between now and May 17th, 2021, you could contribute $4,000 into each Beneficiary’s ESA.
- Step 4. Create a Roth IRA for each Beneficiary that you are also establishing an ESA. This requires that the Beneficiary has earned income up to the contribution amount, not to exceed $6,000. This is a multi-step procedure with lots of moving parts. For more details, see my article: “Paying Your Children in the Business- Young or Old”.
- Step 5. Combine Accounts. Combine the Coverdell ESA accounts and Roth IRA Accounts into one self-directed special purpose LLC (aka. IRA/LLC). This will allow you to pool funds to create a bigger account to use for projects and open up more. For more details, see my YouTube video: “What is an IRA LLC?”
- Step 6. Self-Direct On! Invest the LLC funds in what YOU KNOW best and that ultimately get you the best rate of return.
- Step 7. Make Distributions. Distribute funds for the primary Beneficiary you designated in the beginning.
- Step 8. Change the Beneficiary. If the funds aren’t used entirely by your first Beneficiary before they turn 30, change to another Beneficiary/family member under age 30.
In summary, many a parent understands the seriousness and stress ‘college savings’ can place on a family. However, just as a retirement savings plan, the best strategy is to just start saving now, and in my opinion, start self-directing your Coverdell ESA as soon as possible to reap the highest possible rates of returns. As a parent with 3 kids, and two of their spouses in college this year, let me encourage you to take this seriously and just get started with something and don’t give up.
* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.
Mark J. Kohler is a CPA, Attorney, co-host of the PodCasts “The Main Street Business Podcast” and “The Directed IRA Podcast”, and the author of “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”, as well as several other well-known books. He is also the CFO of Directed IRA Trust Company, and a senior partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP, and the accounting firm K&E CPAs, LLP.