What is a Coverdell education savings account and how does it work?

Coverdell education savings accounts (Coverdell ESA) are tax-advantaged investment accounts designed to help save for college expenses. Any investments you make within a Coverdell ESA grow tax-free.

However, there are notable restrictions on how much you can invest through a Coverdell education savings account. On top of that, this type of account has income limits and lacks tax advantages that may be available with certain 529 college savings plans.

CNBC Select shares how Coverdell ESAs work and the advantages and disadvantages of this type of college savings account.

Coverdell education savings accounts are tax-advantaged custodial accounts that can be set up to help pay for the beneficiary's education expenses. You can deposit after-tax dollars into a Coverdell ESA and withdraw the investment gains tax-free, as long as the funds are used for qualified education expenses. Qualified expenses include things such as tuition, books and supplies for college or K-12 schooling.

The maximum annual contribution limit is $2,000 per year. And you can contribute the maximum if your modified adjusted gross income (MAGI) is under $95,000 for single filers and $190,000 a year for married filing jointly. If your MAGI is higher, the contribution limit is reduced and once your MAGI hits $110,000 for single filers ($220,000 married filing jointly) you are unable to contribute to a Coverdell ESA.

The beneficiary of a Coverdell account must be under 18 years old, and you are only allowed to contribute to a Coverdell ESA until the beneficiary turns 18. There are exceptions to this age restriction for special needs beneficiaries.

Once the beneficiary of the Coverdell ESA turns 30, the funds must be distributed. Any distributions of Coverdell funds that aren't used for qualified education expenses are subject to a 10% penalty and the investment gains are taxable. You can avoid the penalty by changing the beneficiary to someone under 30 or by rolling the funds into another account, such as a 529 savings plan.

In some ways, Coverdell ESAs are more flexible than other education savings accounts. You can have more investment options such as stocks, bonds and mutual funds. And with a self-directed Coverdell ESA, you can invest in alternative assets, such as real estate.

Unlike a 529 plan, where you'll typically have a menu of investment options to choose from, a Coverdell ESA can give you greater control of the account's investment strategy. "You're the one who directs the investments in the account," says Marti Awad, senior vice president and financial advisor at Wealth Enhancement Group. Also, you can typically use Coverdell funds for a wider range of K-12 education expenses compared to other accounts such as a 529 savings plan.

But Coverdell ESAs get more restrictive when it comes to contribution limits for adding and withdrawing funds compared to other types of tax-advantaged education savings accounts. These accounts also have strict rules regarding the age of the beneficiary and when you have to disperse the funds.

Pros

• Funds can be used for a wider range of K-12 expenses
• More investment options
• Tax-free growth on investments

Cons

• $2,000 per year maximum contribution limit
• Cannot contribute after the beneficiary turns 18
• Must disperse the funds when the beneficiary turns 30
• No state tax benefits
• Must fall under the income limits to be able to contribute

When comparing options for college savings, the Coverdell ESA lacks certain benefits available with 529 college savings plans. For starters, many states offer a tax deduction or credit for 529 plan contributions. And some states even give free money for opening or contributing to a 529 savings plan. For example, you can receive $50 when you open a Massachusetts U.Fund College Investing Plan, if the child was born or adopted after January 1, 2020.

And eligible California residents can receive up to $200 in matching contributions to their ScholarShare529 account.

With a Coverdell ESA, you won't receive any state tax deductions on contributions or free money to boost the account.

There are also no income limits for 529 college savings plan contributions. 529 savings plans do have maximum contribution limits and when this limit is hit, no more money can be added to the account. The contribution limit varies by state and, "it's supposed to be linked to what the cost of college is in your state," Awad says. The 529 contribution limits typically range from around $235,000 to $553,000. 529 plans also have no beneficiary age limits for contributions and there is no age where you'll be forced to withdraw the funds.

When it comes to using the money for K-12 education, a Coverdell ESA does give you more options because you can use the money for not only tuition but also books, equipment and other expenses. While 529 plans also cover similar expenses when it comes to higher education, they're stricter when it comes to K-12 education — you're only allowed to use up to $10,00 a year for tuition. And some states' 529 plans don't even count K-12 tuition as a qualified education expense.

You can change the beneficiary of both a Coverdell ESA and 529 savings plan, which is helpful if you won't use up all of the money for qualified expenses. However, starting in 2024, you'll have the option of rolling a 529 savings plan into a Roth IRA. Although there are transfer caps and other restrictions on these rollovers, 529 plans give you more options if you have leftover money in the account.

If you're not sure if a Coverdell or 529 plan is best for you, you can open both types of accounts. But there may not be a big benefit to that strategy. Awad says that unless there's some unique K-12 expense you know you want to be covered by funds from a Coverdell, there's no reason to have both a Coverdell and a 529 account.

A Coverdell education savings account provides a tax-advantaged way to save for education expenses. You can use a Coverdell ESA to pay for qualified college and K-12 expenses. However, compared to a 529 savings plan, Coverdell accounts have additional restrictions that limit your flexibility. Also, 529 plans may have state tax benefits or other incentives that aren't available with Coverdell ESAs.

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