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In 2002, the Education IRA was renamed the Coverdell Education Savings Account.
- Benefits of Coverdell ESAs
- Limitations of Coverdell ESAs
- Coverdell ESA Eligibility and Income Limits
- How Coverdell ESAs Work
- Withdrawals from Coverdell ESAs
These accounts work very much like a 529 plan, offering tax-free investment growth and tax-free withdrawals when the funds are spent on qualified education expenses. However, in addition to college expenses, certain K-12 purchases are also considered qualified when using a Coverdell Education Savings Account (ESA).
Tax-free withdrawals from 529 plans are limited to $10,000 in tuition expenses for K-12 schools, but when using a Coverdell ESA, qualified elementary and secondary education expenses also include books, supplies, equipment, academic tutoring and special needs services in connection with enrollment or attendance at an eligible school.
Also, Coverdell ESAs have much lower maximum contribution limits per child, and they are only available to families below a specified income level.
Education savings account comparisons
Read about what benefits Coverdell education savings accounts have to offer and how they compare to 529 college savings plans.
Compare the features of a Coverdell education savings account with other college savings options side by side: You can modify your comparison by selecting which options to look at, and what features you’d like to compare.
Benefits of Coverdell ESAs
In 2002, the re-named Coverdell education savings account became a very attractive college savings vehicle for many people, including families that wish to save for elementary and secondary school expenses, as certain K-12 expenses were added to the list of qualified expenses. In fact, even if you like the 529 plan you may still decide to contribute the first $2,000 of savings for each child into a Coverdell account. A key distinction between 529 plans and Coverdell ESAs is that ESAs allow you to self-direct investments, while 529 plans only allow you to select from a menu of investment options determined by the program manager.
The ESA is on equal footing with the 529 plan when applying for federal financial aid. The account is considered an asset of the account custodian, typically the parent. Withdrawals are not reported as student or parent income as long as it is tax-free for federal income taxes.
Limitations of Coverdell ESAs
There are certain eligibility requirements in the year you wish to contribute to the ESA, which means that not everyone will find them useful. For example, tax law prohibits ESA funding once the beneficiary reaches age 18.
In 2002, the contribution limit was increased from $500 per child to the much more reasonable level of $2,000. However, you need to be careful when accounts are established by different family members for the same child. If total contributions exceed $2,000 in a year, a penalty will be owed.
The relatively low contribution limit means that even a small annual maintenance fee charged by the financial institution holding your ESA could significantly affect your overall investment return.
Your contribution goes into an account that will eventually be distributed to your child if not used for college. You cannot simply refund the account back to yourself like you can with most 529 plans. This means you lose some degree of control.
How do Coverdell ESAs work?
If you know how a Roth IRA works, then you have a pretty good idea of how an ESAs works. They both allow you to make an annual non-deductible contribution to a specially designated investment trust account. Your account will grow free of federal income taxes, and if all goes well, withdrawals from the account will be completely tax-free as well. You will need to meet certain requirements in the years you wish to make the contributions, and in the years you take withdrawals.
See our list of Coverdell ESA providers
Coverdell ESA eligibility and income limits
The first step in establishing a Coverdell ESA is determine if you are eligible to contribute to an ESA. The beneficiary of the account must be under the age of 18 at the time of the contribution. There is no requirement that the beneficiary be your child or have any other particular relationship.
Also, your income must be below a certain level in the year of your ESA contribution. Contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution. The $2,000 maximum is gradually phased out if your modified adjusted gross income falls between $190,000 and $220,000 ($95,000 and $110,000 for single filers).
You can contribute to both a 529 plan and an ESA for the same beneficiary if you wish. This was not permitted prior to 2002. The next step is to decide where to establish the ESA. Any bank, mutual fund company, or other financial institution that can serve as custodian of traditional IRAs is capable of serving as custodian of an ESA. Your cash contribution can be invested in any qualifying investments available through the sponsoring institution—stocks, bonds, mutual funds, certificates of deposit, etc (but not life insurance).
There is no limit to the number of ESAs that you can establish for any one child (as long as the total contributions stay within the $2,000 limit), but you will probably find that annual fees and sponsor-imposed minimums make multiple ESAs impractical in most situations. You will then need to complete the ESA enrollment forms from the sponsor, including the designation of a beneficiary and a “responsible individual”, and make the contribution.
Coverdell education savings account withdrawals
Your child can receive tax-free withdrawals from a Coverdell ESA in any year to the extent that he or she incurs qualified education expenses (QEE). If your child withdraws more than the amount of QEE, then the earnings portion of that excess is subject to income tax and an additional 10% penalty tax. If you also take withdrawals from a 529 plan in the same year for the same student, you will need to allocate the available QEE between the accounts. The ESA must be fully withdrawn by the time the beneficiary reaches age 30. If it is not, the remaining amount will be paid out within 30 days subject to tax on the earnings and the additional 10% penalty tax.
Tax reporting of Coverdell ESA withdrawals
In any year in which a withdrawal is taken from the ESA (assuming it is not the correction of an excess contribution), your child will receive a Form 1099-Q and will need to determine how much, if any, of the withdrawal is included in taxable income. The instructions for making this computation are contained in IRS Publication 970. If sufficient qualified education expenses are incurred, then none of the withdrawals are taxable and nothing needs to be reported on Form 1040. If some portion of the withdrawal is taxable, then it must be reported on the Other Income line of Form 1040.
If income is reportable because insufficient qualified education expenses were incurred, then your child is probably also subject to the additional 10% penalty tax. Form 5329 must be filed to compute this tax. The additional 10% tax will not apply to withdrawals made due to the beneficiary’s death or disability, or to the extent that the beneficiary receives a tax-free scholarship. Also, it will not apply if the withdrawal is taxable only because qualified expenses were adjusted with the Hope, American Opportunity, or Lifetime Learning credit, nor will it apply to a withdrawal that is a return of an excess contribution.
If I want to move the assets in the ESA to a different financial institution, how do I accomplish this?
You may take a rollover distribution from an existing ESA without triggering tax or penalty if you deposit the funds within 60 days into a different ESA for the same beneficiary or for any other qualifying member of the family. This 60-day rollover may be accomplished only once in a 12-month period.
Can we move the funds from my child’s ESA into a 529 plan?
Yes. A withdrawal from an ESA is tax-free to the extent that contributions are made to a 529 account for the same beneficiary in the same taxable year. Apparently it doesn’t matter if you use your own funds in contributing to the 529 plan when accomplishing this rollover (so that you can be the account owner) or if you use the funds received by your child from the old ESA (in which case it my be more proper that your child or legal representative be the account owner of the 529 plan). Of course if you use your own funds, then you still need to think about what to do with the ESA withdrawal funds in the hands of your child. Your choice of approach may also have different gift tax ramifications.
