How a Coverdell Account Works

An overview of Coverdell education savings accounts.

Coverdell accounts are similar to Roth IRAs in many respects, with the main difference being the intended use of the account (education expenses rather than retirement). In the typical situation, you set up a Coverdell account for your child under 18 years of age with a bank, mutual fund company or stockbroker and contribute up to $2,000 per year. You can't deduct your contributions, but you receive other benefits:

• There's no tax on earnings while they remain in the account, so investments can grow faster than they would in a taxable account.
• When the time comes to pay education expenses you withdraw money from the account. Assuming there are enough qualified education expenses in the year you took the money out, the withdrawal is tax-free — including the part that represents earnings.

If the amount you take out is more than the qualified education expenses, the part of the withdrawal that represents earnings is taxable, and also subject to a 10% penalty tax. If money remains in the account when the child reaches age 30, it has to be distributed within 30 days.
    There are many variations on this theme. As you'll see when we get into the details below:

• The designated beneficiary doesn't have to be your child, or even a relative. According to tax forms issued by the IRS, however, you have to name a parent or guardian of the beneficiary as the responsible person for the account.
• In the case of a "special needs beneficiary," contributions can be made after age 18 and the account can remain in place after age 30.
• You can change the designated beneficiary after the account is set up.
• In some circumstances you can avoid the 10% penalty tax on amounts that are not used for education expenses.

Student Financial Aid Treatment

The federal formula for student financial aid treats a Coverdell account as an asset of the parent. That's fortunate because it means the assets in this account will reduce aid less than if the student were treated as the owner. A parent is expected to contribute less than 6% of the parent's assets towards a child's education, and in some cases the contribution is zero because of various exclusions. A student is expected to contribute 35% of the student's assets toward his or her own education. As a result, for purposes of obtaining student financial aid, a Coverdell account is on a par with a 529 account or a regular investment account held by a parent and receives more favorable treatment than a custodial account under the Uniform Transfers to Minors Act.

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