Unlike 529 plans, the rules governing Coverdell Savings Accounts are dictated by the IRS. Thus, there is no variation in these plans from state to state.
Contributions to Coverdell accounts are not deductible on either a federal or state income tax return. However, similar to 529 plans, earnings withdrawn from these accounts are tax-free if used to cover qualified education expenses. Also similar to 529 plans, funds withdrawn that are not utilized for education expenses are taxed as ordinary income and subject to a 10 percent penalty.
Coverdell accounts offer several advantages over 529 plans. First, the definition of qualified education expenses are broadened to include not only college, but kindergarden thru 12th grade. If you are uncomfortable with guessing whether a child will attend college, but still want to invest in their education, a Coverdell account might be an attractive option. Interestingly, the cost of a computer for elementary and secondary education is counted as a qualified expense under IRS rules (computers are generally not covered under 529 plans unless a college REQUIRES the student to own a computer). Another advantage Coverdell accounts have over 529 plans is that investment options are not limited to only funds offered by the 529 plan. There is a much wider universe of investment options offered in Coverdell accounts.
Coverdell accounts require funds that have not been utilized by age 30 to be distributed, causing the beneficiary to pay taxes and the 10 percent penalty. However, the beneficiary can choose to roll the funds into another Coverdell account for a younger family member to avoid taking distributions. Notice the lack of control by the donor. Once the contributions is made, the donor cannot refund the money to himself or herself, and the beneficiary, not the contributor, has the power to change the beneficiary on the account. Although the contributor lacks control of the funds, note that the account can be owned by either the donor or the student. This decision should be made with care, as it may have an impact on the student’s ability to obtain financial aid.
The main drawback of Coverdell accounts is the contribution limits. Although an unlimited number of accounts can be opened for a beneficiary, the total that can be contributed to all accounts each year is only $2,000. A donor can create several Coverdell accounts with different beneficiaries, but the most that can be contributed to each beneficiary is $2,000 per year.
Contributions to Coverdell Savings Accounts can be made up to the date of the donor’s tax filing, excluding extensions.