By Noah Styles, CPA

Do your kids plan on attending college?  According to a 2019 Bureau of Labor Statistics article[1], 66% of high school graduates in the United States enrolled in college.  With so many high school graduates starting college, a question comes to mind:  how do you pay for college?  Well, if you expect your child to earn a full ride athletic or academic scholarship, then there is nothing to worry about.  Sit back and relax.  If this is not the case, the Coverdell Education Savings Account (ESA) was created with a double tax incentive to help Americans with college expenses.

In this article we will look at some common questions Americans have regarding ESAs. “What is an ESA?”, “Am I eligible for one?”, “How do I open one?”  In 6 minutes, you will know more about ESAs than most people.  Also, you will find out whether or not you should reach out to your Certified Public Accountant (CPA) to inquire about an ESA.

Part of the Taxpayer Relief Act of 1997[2], the ESA was originally called an Education Individual Retirement Account.  At its inception, $500 a year was the maximum amount you could contribute to an ESA.  Contribution limits have since grown to $2,000 per year.  ESAs are a great asset to absorb some if not all college expenses for your child.  This is more important than ever, as according to a Forbes article on student loans, the average student in the class of 2018 graduated college with $29,200 of student loan debt[3].

No, $2,000 a year contribution is not going to become $250,000.  However, if $2,000 a year is invested within an ESA into an index fund like IVV from birth until your child’s 18th birthday, it would look much more like $65,000.  This is figure is based on IVV’s average rate of return of 6% since inception[4] over 20 years ago.  Cash is contributed after tax into an ESA.  Once invested, it grows tax free, and as long as it is used for qualified education expenses, is withdrawn tax free.

What exactly can an ESA be used for?  IRS Publication 970[5] states, ESA funds are withdrawn tax free for qualified education expenses such as tuition, books, computer equipment, internet access, as well as room and board, assuming the beneficiary is at least a half-time student.  A half-time student is defined as a student who is enrolled for at least half the full-time academic work load for the course of study the student is pursuing, as determined under the standards of the school where the student is enrolled.  For example, if Jeremiah University’s full-time student load is 15 credit hours per semester, the beneficiary would need to be enrolled in 8 credit hours.

John and Rebecca Smith have been investing into an ESA for their daughter (Lydia Smith) for 10 years, there is $25,000 in the account.  John and Rebecca use the money to offset some of Lydia’s college expenses.  John and Rebecca have visited with Lydia, and she decides to attend a reasonably price school, and works part-time while she is in college.  The ESA is used to buy a computer for Lydia, and help with tuition as well as room and board.  Lydia is so appreciative of her parents for visiting with her and setting up an ESA, knowing that with the right choice of college and working part-time, she will graduate debt free.

Ok, before you call your CPA or investment advisor to help you open up an account, let’s go over some ground rules for the ESA found in IRS publication 970:

To be eligible to contribute the full $2,000 per year, an individual’s Modified Adjusted Gross Income (MAGI) must be under $95,000 ($190,000 for married filing jointly).  MAGI defined for ESA contribution purposes is Adjusted Gross Income (AGI) + foreign earned income exclusion + foreign housing exclusion + foreign housing deduction + exclusion of income by bona fide residents of American Samoa, and Puerto Rico.   Basically, MAGI for purposes of the ESA for the vast majority of Americans is going to be their AGI.  The due date for contributions to an ESA is the due date of the contributor’s tax return not including extensions.  For example, most American’s 2020 ESA contributions would be due April 15th, of 2021.

No matter how many ESAs have Lydia Smith named as beneficiary, the combined maximum contribution is $2,000.  For example, in 2019, John and Rebecca Smith meet the MAGI requirement and contribute $500 to an ESA for Lydia.  Rebecca’s parents are also under the MAGI requirement for 2019 and contribute $500.  John’s parents meet the MAGI requirement, and want to contribute as well.  The max they can contribute is $1,000 on behalf of Lydia.  As $500 (John and Rebecca) + $500 (Rebecca’s parents) equal $1,000, and the maximum for 2019 is $2,000.

The beneficiary must be born for an ESA to be opened in their name.  So, you cannot open an ESA until baby Lydia is born.  The $2,000 can be contributed for each year until Lydia is 18 years old.  The only exclusion to this criteria is if the beneficiary is special needs.  In this case, money can continue to be contributed past the age of 18.

The ESA must be completely distributed within 30 days after the beneficiary turns 30 years old.  The special needs exclusion applies to this criteria as well.  If, after Lydia graduates from college, $5,000 is left in the ESA, the family has two choices regarding this amount.  First, they could distribute the money to Lydia, in which case, the amount of growth that has occurred since the original contributions is taxed as income and is also subject to a 10% penalty.  For example, of the $5,000 that is left after graduation, $4,500 is contributions and $500 is growth.  The $500 is included in income when the remainder is distributed to Lydia plus a $50 penalty ($500*10%).  Second, the beneficiary could be changed.  The beneficiary can be changed to members of the beneficiary’s family.  For example, the beneficiary could be Lydia’s brother, sister, stepbrother, stepsister, Lydia’s son, daughter, stepchild, adopted child, the spouse of any individual listed above, or Lydia’s first cousin.  See IRS publication 970 for the exhaustive list of people to whom the ESA can be transferred.  If the beneficiary on the account is transferred to a qualified member of the family as listed above, it is not a taxable transfer.  When the new beneficiary uses the money for qualified education expenses, it will be a tax free withdrawal as well.

Okay, it is decision time.  There are generally three groups of people at this point.  The first group, have no children.  Great, you now have an idea for the future, or might be able to help someone who does.  The second group, has children, but do not see the benefit of an ESA.  That is fine, you now know the acronym ESA stands for Education Saving Account.  The third group, has children, are always interested in increasing tax savings, and are interested in helping their child attend college in the future without acquiring excessive debt.  If you are in this camp, read on to see how to open an account.  Of note, ESAs and 529 Plans are independent of each other.  Lydia can take advantage of both a 529 Plan and an ESA without any penalties.

Opening an ESA is fairly simple.  Talking with your CPA about it is a good first step.  ESAs can be opened with pretty much any brokerage firm such as Schwab or TD Ameritrade.  The main thing to watch for when opening an account is the ability to invest it in the market.  It is not helpful for this money to grow at 1% (or less) a year at a bank.

Ultimately, an ESA is not going to make you a millionaire, however, it can help your child become one.  Giving your child the ability to start their post college life without student loans is a huge step in setting them up to become everyday millionaires.  According to the Forbes article referenced above regarding student loans, 8.1 million people over the age of 50 are still making payments on their student loans.  Who wants their child to be part of that statistic?  Reach out to your CPA today regarding an ESA.