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Coverdell ESA (Education Savings Account): The full breakdown

At a glance:

  • What is a Coverdell education savings account?

  • Contribution rules of Coverdell education savings accounts

  • Penalties on withdrawals from a Coverdell education savings account

  • Coverdell education savings account rollovers

  • Summary of Coverdell education savings accounts

The individual retirement account (IRA) that was created to encourage persons to fund their retirements inspired another tax-savings account: The education IRA.

Later named the Coverdell education savings account after its champion in the U.S. government, the late Senator Paul Coverdell, Congress devised this plan to enable Americans to better meet the rising costs of higher education.

The Coverdell can be a very valuable part of your education planning. But just like the individual retirement account, the plan comes with some rules that you must follow in order to avoid penalties. These rules apply to making contributions, taking withdrawals, and rolling over funds.

What is a Coverdell education savings account?

The Coverdell education savings account is a way to save money for a child's qualifying education expenses. It falls under the same section of the tax code as does the individual retirement account, so it shares the misnomer "IRA." Because it falls under rules similar to those of IRAs, the account has tax-savings benefits to encourage persons to save for education expenses.

How they work

Coverdell education savings accounts use tax-free growth of money to fund a child's education. Although the contributions may not be deducted, interest, dividends, and capital gains earned within the account are not taxed.

However, for these benefits, there are contribution rules and penalties on non-qualified withdrawals. As with other IRAs, rollovers between Coverdell education savings accounts are allowed.

The Coverdell education savings account is a convenient way to start saving for a child's education.

Tax issues to remember

One generally cannot take a deduction or tax credit for any educational expense used as the basis for a tax-free withdrawal from a Coverdell ESA. One must weigh the tax consequences of taking a tax-free withdrawal from a Coverdell ESA against other potential tax savings from an educational deduction or tax credit, such as the Hope credit or lifetime learning credit available on IRS Form 1040.

The designated beneficiary may waive the tax-free treatment of the withdrawal and elect to pay any tax that would otherwise be owed on the withdrawal. The beneficiary or the beneficiary's parents may then be eligible to claim a Hope credit or lifetime learning credit.

The cost of college keeps rising across the U.S. (Graphic: David Foster/Cashay)
The cost of college keeps rising across the U.S. (Graphic: David Foster/Cashay)

The effect on student financial aid

Another consideration is the effect of assets in the Coverdell ESA on eligibility for financial aid. Assets in a Coverdell ESA are considered an asset of the account custodian (usually, the parent). This may lower the student's eligibility for financial aid.

The Coverdell ESA has some definite benefits, but it is important to weigh the overall effect on taxes and financial aid against the potential expected family contribution toward higher education.

Contribution rules of Coverdell education savings accounts

Anyone may fund a Coverdell education savings account (formerly education IRA) for a child (beneficiary). The maximum allowed contribution is $2,000 per year in aggregate, up until the beneficiary's 18th birthday, unless the beneficiary is a special-needs beneficiary.

The earnings remain tax-free when they are withdrawn and used for qualified educational expenses. All assets must be distributed within 30 days of the beneficiary's attaining age 30, unless the beneficiary is a special-needs beneficiary.

It is important to note that contributions to Coverdell accounts are not tax deductible.

Limits on your contributions

The full $2,000 may be contributed each year by a single person or married person filing separately as long as the contributor has an adjusted gross income (AGI) less than or equal to $95,000. As soon as the AGI exceeds $95,000, a phase-out will begin. The phase-out will be $100 for each $750 of extra adjusted gross income and will decline to $0 when the AGI reaches $110,000.

For married couples filing jointly, the phase-out starts at $190,000. The contribution allowance drops by $100 for every $1,500 of extra AGI, falling to $0 at $220,000.

For more information

IRS Publication 970 provides more information on Coverdells.

The restrictions discussed above apply per contributor.

A Coverdell account can help you pay for your child's education. (Photo: AP Photo/Seth Wenig, File)
A Coverdell account can help you pay for your child's education. (Photo: AP Photo/Seth Wenig, File)

Penalties on withdrawals from a Coverdell education savings account

There are tax penalties for non-qualified withdrawals from a Coverdell education savings account. Non-qualified withdrawals are those that are not withdrawn for qualified educational expenses. The IRS will consider any non-qualified withdrawal to be taxable income. All such withdrawals are subject to income tax on their earnings as well as the 10 percent penalty on early distributions. In the event of the death or disability of the beneficiary, the 10 percent penalty will not apply.

There are tax penalties for "non-qualified" withdrawals.

Other penalties

A 6 percent penalty tax is charged on excess contributions (contributions over the legal maximum); this tax will apply to each year that the excess remains. If there are any unused funds in the account when the beneficiary reaches age 30, they must be distributed to him or her as a taxable withdrawal. Rolling these funds over within 60 days to another Coverdell account for a family member under age 30 can preserve their tax-free status.

Coverdell education savings account rollovers

Rollovers may take place without tax consequences in the following ways:

  • They are rolled over to a member of the beneficiary's family (including the beneficiary's spouse) who is under age 30. According to IRS Publication 970, the following count as members:

    • The beneficiary's spouse

    • Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.

    • Brother, sister, stepbrother, or stepsister.

    • Father or mother or ancestor of either.

    • Stepfather or stepmother.

    • Son or daughter of a brother or sister.

    • Brother or sister of father or mother.

    • Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.

    • The spouse of any individual listed above.

    • First cousin.

  • If rolled over into new investments, they are for the same beneficiary.

  • They are rolled over within 60 days.

Any amount may be rolled over.

Summary of Coverdell education savings accounts

In the 1990s, Congress approved the use of special accounts for higher education. As an incentive to use these accounts, Congress also approved income tax savings for them.

If you are familiar with the individual retirement account, you already have a head start in understanding Coverdell accounts. The two fall under the same section of the tax code, in fact. They have similar rules to follow regarding contributions, withdrawals, tax benefits, and penalties.

As you can see, the Coverdell is a valuable investment strategy that can reap huge savings for you. Another advantage is that it can be established long before the recipient enters college. As with the traditional individual retirement account, this education-savings plan will probably evolve over the years: it will likely change to meet the needs of Americans looking to rein in the rising costs of higher education.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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