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Coverdell Educational Savings Account (ESA)

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Like the 529 College Savings Plan, the Coverdell Educational Savings Account (ESA) is a tax advantaged college savings vehicle. However, there are some major differences between the two types college savings accounts. This article will cover the major features of Coverdell ESAs, and a later article will compare the two accounts.

How does a Coverdell Educational Savings Account work?

The Coverdell ESA works much like a Roth IRA, and at one point was called the Education IRA. Contributions are non-deductible and grow tax free. Withdrawals are also tax free for qualified higher education expenses. Some examples of qualified expenses include tuition and fees, books, supplies and equipment, and in many cases, room and board.

One feature that sets it apart from the 529 plan is the ability to use it for qualified expenses at any education level, including kindergarten to high school and post secondary (college level), provided the school is eligible to accept Coverdell funds.

Coverdell ESA eligibility

The beneficiary of the Coverdell ESA must be younger than 18 at the time the contribution is made and the assets must be used or transferred to another beneficiary by the time he or she turns 30. There is no limit to how many accounts can be opened per person, however, the total annual contributions to the recipient cannot exceed $2,000 per year from all sources.

ESA Contribution and income limits

To be able to contribute the maximum amount, contributors must have an AGI lower than $95,000 for single filers and $190,000 for joint filers. Contribution limits are phased out for AGI levels between $95,000 – $110,000 for single filers and $190,000 – $220,000 for joint filers. To avoid the income limits and make the full contributions, you can gift the money to the minor and they can contribute it to their own Coverdell ESA.

Where to open a Coverdell Educational Savings Account

You can open a Coverdell ESA at almost any traditional or online brokerage, along with many banks, mutual fund houses, and any financial institution which can serve as a custodian for a Traditional IRA. The contribution deadline is the same as the tax filing deadline, or April 15th in most years. The contributions can be invested in stocks, bonds, mutual funds, CDs, and similar investments.

Coverdell ESA withdrawals

Coverdell ESA withdrawals can be used for qualified expenses for students attending K-12 and/or higher education. Withdrawals are tax free if used for qualified expenses, otherwise the recipient may be required to pay early withdrawal penalties on the funds.

Use it, transfer it, or pay taxes

The money contributed to a Coverdell ESA is for educational use only, and you cannot withdraw your contributions for personal use (which differs from the 529 College Savings Plan). If the beneficiary does not use the assets in the Coverdell ESA by the time they turn 30, then there are two options for the money:

  • Assets are automatically distributed and will be subject to taxes and penalties.
  • Assets can be transferred to another relative.

Coverdell ESA accounts offer tax benefits but have some limitations

ESAs offer great tax benefits for college savings but they are somewhat more restrictive than the 529 College Savings Plan. The biggest downsides are the $2,000 per year maximum contribution and the requirement to use the assets by age 30.

More college savings articles:


Published or updated May 25, 2011.
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{ 16 comments… read them below or add one }

1 Miranda

Thanks for this information on the Coverdell. We’re trying to decide whether to go with a Coverdell, 529 or both. We want our son to help by contributing his own money as well.

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2 My Journey

CashMoney,

A planner came into my office today, and asked me why would anyone choose the Coverdell? I can’t think of one reason – can you?

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3 Ryan

My Journey: The biggest reason someone would open a Coverdell is that you can change the asset allocation and investments at will, where you can only do it twice per year with a 429 plan. There are a couple other small reasons, but overall, I think the 529 is a more flexible plan.

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4 Michelle

Ryan:
Does the contribution limit of $2,000 apply if a Coverdell account is transferred to another relative? What if the amount to be transferred is more than $2,000?

Thanks.

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5 Ryan

Michelle, The $2,000 is the max any one person can have contributed to his or her account in any given year, regardless of how many people contribute to it. For example, you could contribute $1,000 to your child’s fund and your parents could also contribute another $1,000 to the fund and it would be maxed out. You couldn’t both contribute $2,000. I believe the limit only applies to contributions; I’m not sure about transfers.

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6 Paul

Can a Coverdell ESA be used for expenses related to homeschooling, for example textbooks, resources materials, educational videos?

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7 Ryan

Paul, I believe so, I would just recommend keeping receipts of everything so you can prove the costs were school related, should there ever be any questions about it. If you are unsure, then I recommend contacting your plan administrator or a tax professional for more information.

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8 Ben

Did Congress act to keep the limit at $2,000 or has it reverted to $500?

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9 Ryan

Ben, From what I have seen, the limits are $2,000 for 2010.

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10 Lisa

Can you make withdrawels for your child to attend private school? could I essentially add $2000 per year for the tax advantage then make withdrawels to cover the tuition montly costs? Thanks for your help

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11 Ryan

Lisa, ESA contributions can be used for education from K-12 and for higher education, such as college. It looks as though you may be able to make withdrawals for private school, but I recommend contacting your ESA provider for verification.

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12 Robert H. Kille

Two children, one 17 and one 12, both with Coverdell ESA’s. The 17 year old has dropped out of high school and shows no interest in school (or much of anything else). The 12 year old is a good student. Neither child knows that they have an ESA. Can the older child’s ESA be transferred to the younger, without their being involved in the transfer? And, should this be done now or just leave it as is until the younger child is ready to go off to college?

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13 Ryan

Robert, to be honest, I don’t know. I recommend contacting a tax professional regarding this situation.

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14 Jack Smith

This is such an easy question yet I can’t find a simple clear answer to this after two hours on the net. With a NON deductible ROTH IRA, meaning you have paid taxes on the contributions, you CAN withdraw those contributions only, NOT earnings, without any IRS tax penalties. ONLY THE CONTRIBUTIONS! I know for we have done this twice now. Suzie Orman talks a lot about this!

My question is can one do the same for a COVERDELL education non deductible IRA well? That is, take out the CONTRIBUTION amount ONLY and USE THAT MONEY for anything? None of the financial companies seem to want to let people KNOW that contributions to a non deductible ROTH IRA, meaning the contribution is ALREADY taxed, and therefore, can be withdrawn for emergency purposes. I just want to know if the CONTRIBUTIONS only can be withdrawn from a Coverdell education account for the same purpose? To be used for anything tax penalty free? Such a simple question and nobody will mention it on these websites! The financial companies don’t want people to know they can take that money out!

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15 Ryan

Jack, I don’t believe it is possible to do this, however, I recommend speaking with a tax professional to be 100% certain. Based on everything I have read, contributions to a Coverdell account become the property of the person in whose name the contributions are made, and tax free withdrawals can only be made for educational purposes. Again, I recommend speaking with a tax professional for further guidance.

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16 Terri

Hi,
For tax year 2011, did Congress allow the contribution limit to stay at $2,000 or is it down to $500 for Coverdell ESA’s? Thank you

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