The Education IRA Is Also Called the Coverdell ESA: Key Facts
Learn how a Coverdell ESA works, including contribution limits, tax benefits, and withdrawal rules, to help you plan for education expenses effectively.
Saving for education can be challenging, and choosing the right savings account is an important decision for families. One option designed for educational expenses is the Coverdell Education Savings Account (ESA), previously known as the Education IRA.
This account offers tax advantages and flexibility in covering a range of education costs. Understanding how it works, who qualifies, and how it compares to other options can help families make informed financial decisions.
Definition of Coverdell ESA
A Coverdell Education Savings Account (ESA) is a tax-advantaged trust or custodial account created to pay for education expenses. Unlike other savings plans, it covers both K-12 and higher education costs. The account must be set up for a named beneficiary under 18 or a special needs beneficiary.
A Coverdell ESA functions similarly to an individual retirement account (IRA) but is strictly for education. It is typically opened through a bank, brokerage firm, or mutual fund company, and funds can be invested in stocks, bonds, mutual funds, and exchange-traded funds (ETFs). This investment flexibility allows savings to grow over time, though it also introduces market risk.
Eligibility Criteria for Coverdell ESA
To open a Coverdell ESA, contributors must meet income requirements. In 2024, single filers must have a modified adjusted gross income (MAGI) below $110,000, while joint filers must be under $220,000. Contributions phase out for single filers earning between $95,000 and $110,000 and joint filers earning between $190,000 and $220,000. Those exceeding these limits cannot contribute.
The beneficiary must be under 18 when the account is established unless they have special needs. Once the beneficiary turns 30, any remaining funds must be withdrawn within 30 days unless transferred to an eligible family member. This transfer option allows families to reallocate unused funds and avoid tax penalties.
Contribution Limits and Rules
Coverdell ESAs have an annual contribution limit of $2,000 per beneficiary, regardless of the number of accounts in their name. If contributions exceed this limit, a 6% excise tax applies to the excess amount each year it remains in the account.
Contributions must be made in cash and are not tax-deductible at the federal level. However, investment earnings grow tax-free if used for qualified education expenses. Contributions can only be made until the beneficiary turns 18 unless they have special needs. Early planning is essential to maximize the account’s benefits.
Tax Advantages of Coverdell ESA
Investment earnings in a Coverdell ESA grow tax-free as long as withdrawals are used for qualified education expenses. Unlike taxable brokerage accounts, where capital gains and dividends are taxed, Coverdell ESA earnings are not immediately taxed.
Withdrawals for education costs are also tax-free. If funds are used for non-qualified expenses, the earnings portion of the withdrawal is taxed and incurs a 10% penalty. This penalty is waived if the beneficiary receives a tax-free scholarship, attends a U.S. military academy, or passes away before using the funds.
Qualified Expenses for Coverdell ESA
Coverdell ESA funds can be used for a wide range of educational expenses, covering both K-12 and college costs. For primary and secondary education, eligible expenses include tuition, books, supplies, tutoring, uniforms, and transportation if required by the school. Special needs services and technology-related costs, such as computers and internet access, also qualify if used primarily for education.
At the college level, funds can cover tuition, mandatory fees, room and board (for students enrolled at least half-time), and necessary equipment like lab supplies. Unlike 529 plans, which have stricter limitations, Coverdell ESA funds can be used for private, religious, and vocational schools. If funds are used for non-qualified expenses, the earnings portion of the withdrawal is taxed and subject to a 10% penalty.
Comparison with Other Education Savings Accounts
Families often compare Coverdell ESAs to 529 plans, as both offer tax advantages. A key difference is the contribution limit—Coverdell ESAs cap contributions at $2,000 per year, while 529 plans allow much higher limits, often exceeding $300,000 depending on the state.
Coverdell ESAs offer more investment flexibility, allowing account holders to choose individual stocks, bonds, and mutual funds, whereas 529 plans typically offer pre-selected investment portfolios. Coverdell ESAs also cover a broader range of K-12 expenses, including private school tuition and educational technology, while 529 plans limit K-12 tuition withdrawals to $10,000 per year.
Another difference is income eligibility. Anyone can contribute to a 529 plan, but Coverdell ESA contributions are restricted based on income. Families with higher earnings may not qualify for a Coverdell ESA, making a 529 plan the more accessible option.
Withdrawal Rules and Penalties
Withdrawals from a Coverdell ESA must be used for qualified education expenses to remain tax-free. If a withdrawal exceeds eligible expenses, the earnings portion is taxed and incurs a 10% penalty.
Once the beneficiary turns 30, any remaining funds must be withdrawn within 30 days unless transferred to a qualifying family member under 30. If not transferred or used for education, the earnings portion is taxed and subject to the 10% penalty. Exceptions exist if the beneficiary becomes disabled or passes away, allowing funds to be withdrawn without penalty.
Impact on Financial Aid
Coverdell ESA funds are considered parental assets if the account is owned by a parent, meaning they are assessed at a maximum rate of 5.64% in the Expected Family Contribution (EFC) calculation on the Free Application for Federal Student Aid (FAFSA). This is more favorable than student-owned assets, which are assessed at 20%.
Withdrawals used for qualified education expenses do not count as income on the FAFSA, preserving financial aid eligibility. However, if a grandparent or non-parent owns the account, withdrawals may be treated as untaxed student income, which can significantly reduce financial aid eligibility. Families should carefully consider account ownership when planning for college funding.