This past fall, my wife and I were crestfallen when we heard that future contributions to Coverdell Education Savings Accounts (ESAs) would be phased out as part of the tax legislation package being written into law in Washington D.C. Fortunately, Coverdell accounts were eventually left alone in the final version of the bill. While Coverdell ESAs are not widely used, they offer a tax-advantaged way for parents and other loved ones to save for a kid's education expenses.
As a father of four, I'm well aware how much college is likely to cost by the time my kids graduate high school, and I've extensively researched my family's options. While there's nothing wrong with funding 529 savings plans for children and leaving it at that, let me explain why we've chosen to use Coverdell accounts in conjunction with 529 plans to fund our children's future education costs. Specifically, I love Coverdell ESAs because their unique design makes them a fantastic way to teach your kids about investing in stocks, which is vital to their future financial security.
What is a Coverdell ESA?
It might be easiest to think of a Coverdell ESA as a Roth IRA intended for education savings rather than retirement. As with a Roth, contributions to the account are not eligible for an up-front tax deduction, but investment gains, as well as qualifying withdrawals made for qualified educational expenses, are tax-free. Beneficiaries can have more than one account, but no more than a combined $2,000 can be contributed to a beneficiary's accounts during a calendar year. Qualified withdrawals can be made for tuition, room, board, and school supplies.
Although no contributions can be made to the account after the beneficiary turns 18, qualified withdrawals can made until the beneficiary turns 30.
Because Coverdells are designed for low-income and middle-class families, contributions begin to be phased out once the contributor's modified adjusted gross income reaches $95,000 for single tax filers and $190,000 for married couples filing jointly.
Why I love Coverdell ESAs
One significant advantage formerly enjoyed by the Coverdell ESAs over 529 Savings Plans was eliminated by the recently passed Tax Cuts and Jobs Act. Coverdells used to be unique in that parents could also use them to fund their children's private school education with them. However, with the passage of the new legislation, 529 Plans can now be used for this purpose as well.
In the eyes of many, that probably negated any advantage the Coverdell held over its more popular counterpart. But there is still one huge feature, in my eyes at least, that Coverdell ESAs continue to hold over 529 Plans: With Coverdells, investments can be made in virtually any type of equity imaginable, including stocks, ETFs, mutual funds, and bonds. With 529 Plans, parents are stuck with a limited number of choices -- sometimes nothing more than age-appropriate target-date funds.
A great educational tool
This wide range of investment options not only gives investors a chance to beat the market, but offers parents an excellent opportunity to teach their kids about stocks. When my eldest son reached an appropriate age, I did my best to explain to him what stocks are and how they work. After working through a few basic examples, I had him make a list of about 10 companies. A few of these were private companies such as Ikea, the furniture maker. However, the rest were not only public companies, but also solid investment opportunities. We eventually settled on Walt Disney Co (NYSE:DIS) and Amazon.com, Inc (NASDAQ:AMZN) that first year. I bought the same stocks for the other kids' Coverdell accounts.
Each year, we go through the same basic process, and I show him the gains of his previous stock selections. Each year, I try to add a step in research so he can learn a bit more. The past two years, I have had him pick his companies from a stock-picking newsletter that has beaten the market consistently since its inception. I always tell him that although he won't understand everything he reads, he should try to pick up on as much as he can, and I'm there to answer questions.
After he makes his list, I have him read the original recommendation and write a couple of sentences describing why he likes each of the companies he selected. He knows, though, that I have veto power over two companies from his original list. After his research, he picks the two he likes best, and we invest $1,000 in each (totaling the maximum $2,000 annual contribution to his Coverdell account). Up until this year, his picks have also gone into his siblings' accounts, but next year his oldest sister will join him in the stock-picking fun.
As it currently stands, my kids are well ahead of the market and are not currently down on any stock pick my eldest has made. To date, he has built up a portfolio consisting of Alphabet, Amazon, Disney, Facebook, PayPal Holdings, Skechers USA, and Skyworks Solutions. Many of these have been repeat picks over the years, and we have never sold out of a position from any of my children's accounts.
This year, for the first time ever, my wife and I will have more to contribute to our kids' college savings than the $2,000 that can go into their Coverdell accounts, so we'll be opening up 529 Plans with additional funds. Thankfully, we will still be able to make contributions to our kids' Coverdell accounts -- allowing us to save for college, beat the market, and teach our children about investing all at once.