Some of the favorable provisions of Coverdell educational savings accounts (“Coverdell ESA”) are slated to expire by December 31, 2010 if Congress does not extend the current rules. Two of the more significant changes include a reduction in the annual contribution amounts and in how Coverdell ESA funds can be used.
Coverdell ESAs are tax-advantaged educational savings accounts that can be set up for minors to pay for their educational expenses. This type of account, which was formerly known as an “Educational IRA”, allows after-tax dollars to be set aside to pay for qualified educational expense for grades kindergarten through 12 and college. Similar to IRA accounts, contributions into an ESA grow tax-free and distribution are tax free when used to pay for qualified educational expenses such as tuition, fees, books, supplies, room and board.
The current annual contribution limit of $2,000 for Coverdell ESAs is expected to revert back to their 2001 limits of $500 per year. In addition, there will be significant changes to how Coverdell ESA funds are used. Currently, funds in a Coverdell ESA can be used for qualified college expenses as well as expenses for kindergarten through 12th grade. Starting in January 2011, existing Coverdell ESA funds as well as any future contributions can only be used for qualified college expenses.
Unless Congress intervenes these changes will affect those with existing Coverdell accounts differently. For those who have or are planning to start a Coverdell ESA for the purpose of using it to pay for a child’s college expenses, you can continue to fund the Coverdell (albeit at the lower amounts) or consider transferring it into a 529 plan. For those who have a Coverdell for the purpose of funding a child’s K through 12 education, your choices are more limited. You can withdraw the funds in the existing account and spend it on qualified K through 12 educational expenses before the changes go into effect in January or you can leave the funds in the Coverdell and consider using it for the child’s future college expenses.