Coverdell Education Savings Account: A Comprehensive Guide

Opening a college savings account is a smart way to invest in the education of a family member, a friend, or even yourself. There are multiple ways to save for higher education-some with tax benefits-and what works best for you will depend on your (or your loved one's) personal needs and life goals. A Coverdell Education Savings Account (ESA) may be an easy way to start saving for a child’s education. Formerly known as an Education IRA, a Coverdell Education Savings Account (ESA), is a federally sponsored, tax-advantaged trust or custodial account set up to pay for qualified education expenses.

Understanding Coverdell ESAs

A Coverdell education savings account (Coverdell ESA) is a trust or custodial account set up in the United States solely for paying qualified education expenses for the designated beneficiary of the account. Coverdell ESAs have two primary parties: a trust or custodian, who manages the account, and a beneficiary, who receives distributions from the account. The trust or custodian is the party that establishes and controls the funds in the ESA for the student beneficiary, who must be under the age of 18 at the time of designation. Funds within the account are not considered to be owned by the custodian nor by the beneficiary unless they are the same individual.

Key Features of a Coverdell ESA

Tax Advantages: Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax-free until distributed. The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution.
Contribution Limit: The contribution is limited to $2,000 a year for each beneficiary until the age of 18.
Investment Flexibility: Coverdell ESAs are self-directed investment accounts. Unlike bank deposit accounts, such as checking or savings accounts which are pure cash holdings and are typically insured, ESAs can contain both cash and investment securities such as stocks, bonds, real estate funds, and mutual funds. The value of these securities is not insured. This means the value of the funds in an ESA may rise and fall with the respective values of the securities held in the account. Coverdell ESAs may be opened with any investment brokerage institution who select a wide range of securities for the custodian to choose.
Broad Range of Qualified Education Expenses: This benefit applies not only to qualified higher education expenses but also to qualified elementary and secondary education expenses.
Eligibility: Coverdell ESAs can be opened for any student who is under the age of 18 years. The assets, however, must be withdrawn by the time the student reaches the age of 30. Accounts for beneficiaries with special needs generally are not subject to the age restrictions on contributions and withdrawals.

Contribution Rules and Limits

You may be able to contribute to a Coverdell ESA to finance the beneficiary's qualified education expenses. Contributions must be made in cash, and they're not deductible. Any individual whose modified adjusted gross income is under the limit set for a given tax year can make contributions. Organizations, such as corporations and trusts can also contribute regardless of their adjusted gross income. Contributors must contribute by the due date of their tax return (not including extensions).

Contribution Eligibility and Restrictions

Who Can Contribute: Parents, grandparents, other relatives, friends, and the child for whom the account is being established can contribute to a Coverdell ESA. Since 2002, organizations, such as corporations and trusts, have also been permitted to invest in a Coverdell ESA.
Income Limits: Contributions can be made by individuals with modified adjusted gross income of less than $110,000. Joint filers with a MAGI of less than $190,000 ($95,000 for single filers) can contribute up to the full amount. Contribution limits are lower at higher MAGIs and are completely phased out for joint filers with a MAGI of $220,000 or more ($110,000 for single filers). Contributors with a higher modified adjusted gross income, or MAGI, of $95,000+ for single tax filers or $195,000+ for joint filers may not contribute the full $2,000 limit.
Contribution Deadline: Contributors must contribute by the due date of their tax return (not including extensions).
Annual Limit: Each ESA plan can only receive a total of $2,000 in contributions per tax year. Individuals may contribute to any number of accounts per tax year as long as each plan does not exceed the $2,000 contribution limit.
Age Limit: The beneficiary must be under age 18 during the year of contribution (unless he or she is a special-needs child).

Qualified Education Expenses

In general, the designated beneficiary of a Coverdell ESA can receive tax-free distributions to pay qualified education expenses. The distributions are tax-free to the extent the amount of the distributions doesn't exceed the beneficiary's qualified education expenses. If a distribution exceeds the beneficiary's qualified education expenses, a portion of the earnings is taxable to the beneficiary. Coverdell ESA withdrawals can be used to pay for qualified education expenses at elementary and secondary schools (K-12), including public, private, or religious schools, as well as any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education.

Eligible Expenses

Coverdell ESAs can be used only to pay for qualified education expenses, such as tuition and fees; the cost of books, supplies and other equipment; and in some situations, the cost of room and board. Qualified expenses include, but are not limited to, tuition and fees, books and supplies, room and board, and some special needs services if required by the student.

Read also: Learn About Coverdell ESAs

Distribution Timing and Rules

Coverdell ESA distributions may be made at any time. As long as the distribution is applied to payment of the qualified education expenses of the designated beneficiary, it will generally not be considered taxable income for the beneficiary. Amounts remaining in the account must be distributed within 30 days after the designated beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary. If the beneficiary dies before attaining the age of 30, amounts remaining in the account must be distributed within 30 days after the date of death.

Timing of Distributions: Coverdell ESA distributions may be made at any time.
Tax Implications of Distributions: As long as the distribution is applied to payment of the qualified education expenses of the designated beneficiary, it will generally not be considered taxable income for the beneficiary. If a distribution exceeds the beneficiary's qualified education expenses, a portion of the earnings is taxable to the beneficiary.
Age Restrictions: Coverdell ESA assets generally must be used before the student reaches the age of 30 years. (Special needs beneficiaries are not subject to any age restrictions.) At that point, any remaining funds will be distributed to the beneficiary, and the earnings portion generally will be considered taxable income of the beneficiary. The money must be used (or transferred to another beneficiary) within 30 days after the child turns 30.

How to Open and Manage a Coverdell ESA

Anyone can set up an ESA at a brokerage or other financial institution, or directly with a mutual fund company. Once an ESA is opened in your child's name, anyone can contribute as long as they follow a few rules:

Steps to Open and Contribute

Open an Account: Anyone can set up an ESA at a brokerage or other financial institution, or directly with a mutual fund company.
Contribution Rules: Once an ESA is opened in your child's name, anyone can contribute as long as they follow a few rules:
- No more than $2,000 per year can be put in a child's ESA(s).
- The beneficiary must be under age 18 during the year of contribution (unless he or she is a special-needs child).
- The $2,000 maximum is dependent on your filing status and modified adjusted gross income (MAGI).
- The money must be used (or transferred to another beneficiary) within 30 days after the child turns 30.
- You can change the beneficiary to another family member once per year.
- You have until Tax Day of the following year to contribute for the previous year.

Alternative Options and Flexibility

Like with 529 savings plans, if your child decides not to attend college, or there is money left in the ESA account after he or she graduates, the remaining savings can still be used. Unlike with a 529 savings plan, an ESA must be distributed within 30 days after the designated beneficiary reaches age 30, unless he or she is a special needs beneficiary. You can change the beneficiary on the account to another member of the original beneficiary's family who is under age 30. The IRS broadly defines the term "family member" to include everyone from siblings and parents to stepsiblings and in-laws.

If you withdraw funds for non-qualified expenses, any untaxed earnings are taxable to the beneficiary, along with a 10% federal penalty.

Coverdell ESA vs. 529 Plans

Coverdell ESAs have many similarities and differences to a 529 Plan, another tax-advantaged investment account aimed at helping students pay for their education. ESAs offer access to a broader selection of investments than a typical 529, and don't have the 529's $10,000 tax-free withdrawal cap for qualified expenses to an elementary or secondary public, private, or religious school. Unlike 529 plans, there's an income eligibility limit and a relatively low limit on contributions. The annual maximum is $2,000 per beneficiary-or less for higher earners-which means if you (as a parent) contribute all $2,000, grandparents and other individuals aren't allowed to make additional contributions to the account during that year. The good news is your child can be the beneficiary of both a 529 plan and an ESA, and you can contribute to both accounts in the same year.

Financial Aid Implications

ESAs generally receive favorable treatment when it comes to calculating financial aid eligibility, similar to a 529 plan. (With a 529 held in a parent's name, typically up to 5.64% of the assets are considered available for college expenses). However, schools might use slightly different formulas to calculate financial aid eligibility, which could mean ESA accounts listed under a grandparent or non-relative's name might have to be reported. Saving and investing for college is a wise move, even if you believe your child may qualify for financial aid.

Tax Reporting

You should receive a Form 1099-Q, Payments from Qualified Education Programs (Under Sections 529 and 530) from each of the Coverdell ESAs from which you received a distribution.

Economic Impact

Since Coverdell ESAs are tax-advantaged, they impact federal tax revenues. The annual revenue lost to the IRS is small at about $100 million per year, or roughly less than 10 times less than the revenue loss generated by 529 plans. ESAs also reduce federal government expenditures since savings assets such as Coverdell accounts typically lower the amount of financial aid a student is eligible to receive. The impact of this reduction of federal student aid impacts students and their families differently.

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