DEFINITION of 'Coverdell Education Savings Account (ESA)'

A Coverdell Education Savings Account is a tax-deferred trust account created by the U.S. government to assist families in funding educational expenses for beneficiaries 18 years old or younger. The age restriction may be waived for special needs beneficiaries. While more than one ESA can be set up for a single beneficiary, the total maximum contribution per year for any single beneficiary is $2,000.

BREAKING DOWN 'Coverdell Education Savings Account (ESA)'

Formerly called an education IRA, the ESA allows families to increase investment earnings through tax-deferral as long as the funds are used for educational purposes.

For example, if you contributed $500 to an ESA and it appreciated to $5,000 in 10 years, the earnings would not be taxed until the account's owner was enrolled in a post-secondary institution. When the contributions are distributed, they are tax-free assuming that they are less than the account holder's annual adjusted qualified education expenses. The accounts in some cases can also be put towards tuition expenses for elementary schools. Coverdell ESA’s are only available to families that fall under a designated income level.

In the event that the distributions are higher than the expenses, the gains are taxed at the account holders' rate, rather than the contributor's rate, which is typically higher.

Understanding Coverdell Education Savings Accounts 

ESA’s may be established at brokerages and other financial institutions. These accounts are comparable to another tax-free college savings plan, 529, with a number of differences. There is no annual limit on the amount that may be deposited into a 529 plan. Furthermore, there are no restrictions on the income level of the contributors to a 529 plan. However, fees can be extracted from 529 accounts and the investment can also lose money as there are no guaranteed returns on such plan. It is permissible to have a 529 plan as well as an ESA for the same beneficiary’s education expenses.

The contributions put toward a Coverdell ESA must be made in cash and are not deductible. Contributions can be made by individuals with modified adjusted gross income that falls within an annual limit. In addition to individuals, corporations and trusts may make contributions to an ESA without the restriction on adjusted gross income.

Upon the beneficiary reaching age 30, any remaining funds in the ESA must be disbursed. The exception to this rule is if the beneficiary qualifies as a special needs beneficiary. It is also possible to make certain transfers from the account to members of the beneficiary’s family.

RELATED TERMS
  1. Education IRA

    An education IRA is a tax-advantaged investment account for higher ...
  2. Form 1099-Q

    A Form 1099-Q is an IRS form that an individual who receives ...
  3. 529 Plan

    A 529 plan is a tax-advantaged account for saving and investing ...
  4. Primary Beneficiary

    A primary beneficiary is the first person in line to receive ...
  5. IRS Publication 970

    IRS Publication 970 is an explanation of the tax benefits associated ...
  6. Discretionary Beneficiary

    Discretionary beneficiaries are individuals or entities that ...
Related Articles
  1. Financial Advisor

    Why Coverdell ESAs May Trump 529 Plans

    Coverdell ESAs still trail 529 plans in popularity by a wide margin due to their low contribution limits. But these accounts can be a viable alternative.
  2. Personal Finance

    529 Plan Tutorial

    This comprehensive guide goes through what a 529 plan is and how to set one up, contribute to it and withdraw from it.
  3. Personal Finance

    529 Plan or Coverdell? How to Choose College Savings Plans

    There are two options when it comes to tax-free college savings plans: a 529 plan or a Coverdell ESA. Here's how they compare.
  4. Personal Finance

    Save for College With a 529 or Coverdell ESA Plan

    Two options for saving for college are the 529 plan and the Coverdell Education Savings Plan.
  5. Retirement

    4 Smart 529 Plan Alternatives to Consider

    Learn about some alternatives to the popular college-saving 529 plan that may also make sense, such as prepaid tuition plans and Coverdell accounts.
  6. Retirement

    Analyzing IRA And ESA Statements

    Learn how to read and verify 5498 and 5498-ESA reporting your retirement-account contributions.
  7. Financial Advisor

    Top Estate Planning Tips for 401(k)s and IRAs

    Here's how to avoid estate planning pitfalls when it comes to leaving IRA and 401(k) assets to heirs.
  8. Retirement

    A Look at Protecting Children With an IRA Trust

    Too many people make huge and irreversible mistakes when naming the beneficiaries for their retirement accounts.
  9. Personal Finance

    Are 529 College Savings Plans Right For You?

    The 529 College Savings Plan may be the most popular of its type, but does it fit your needs?
RELATED FAQS
  1. What options do I have to save for my child's education?

    There are numerous options available to invest savings for a child's education: State-sponsored "529" college savings plans: ... Read Answer >>
  2. What are the pros and cons of naming a trust as the beneficiary of a retirement account?

    Learn more here about the pros and cons of naming a trust as the beneficiary of a retirement account. Read Answer >>
Trading Center