Coverdell Education Savings Account (ESA): How They Work

What Is a 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 who must be under the age of 18 when the account is established. 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.

Key Takeaways

  • Coverdell funds can be used to pay for a wide variety of expenses for young people (grades K-12) attending eligible schools. 
  • Coverdell funds must be used by the time a student is age 30 or taxes, fees, and penalties will accompany withdrawals. 
  • The cut-off amount for family member contributions to a Coverdell Education Saving Account is $2,000 a year. 
  • The $2,000 contribution is based on the AGI of the taxpayer making the contributions. The contribution amount is phased out above an AGI of $110,000 for single filers and $220,000 for joint filers.
  • Coverdell accounts are similar to 529 plans; however, for elementary and secondary school, Coverdell funds are allowed for tuition and other school expenses whereas 529 plans only allow funds to be used for tuition.

How a Coverdell Education Savings Account (ESA) Works

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 they are less than the account holder's annual adjusted qualified education expenses, including tuition, books, equipment, special needs services, and even academic tutoring. ESA account funds can be used for primary and secondary schools (grades K-12) as well as higher education.

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

The Coverdell ESA is only available for families below a certain income level based on their adjusted gross income. The AGI requirements are $95,000 or below for single taxpayers and $190,000 or below for married taxpayers for the full $2,000 contribution limit. The contribution limit is lower for higher earners and is phased out for single taxpayers with an AGI of $110,000 or more and for joint filers with an AGI of $220,000 or more.

Coverdell Education Savings Accounts vs. 529 Plans

ESAs 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.

In December 2019, the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) expanded 529 plan regulations, and now 529 plans can be used to pay off up to $10,000 in student loans and to pay for qualified expenses related to apprenticeship programs approved by the U.S. Department of Labor.

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 plans. It is permissible to have a 529 plan as well as an ESA for the same beneficiary’s education expenses.

Special Considerations

The contributions put toward a Coverdell ESA must be made in cash and are not deductible. 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, unlike a 529 plan. 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.

What Is the Difference Between a 529 and a Coverdell?

The key difference between a 529 and a Coverdell when used for elementary and secondary schools is that a 529 can only be used for tuition whereas a Coverdell can pay for tuition as well as other school expenses.

How Much Can You Contribute to a Coverdell Account?

The annual contribution limit for a Coverdell account is $2,000 per beneficiary. This is for single taxpayers with an AGI of $95,000 and below and joint taxpayers with an AGI of $190,000 or below. Above these AGI levels, the contribution amount is reduced and completely phased out for single taxpayers with an AGI of $110,000 or more and joint taxpayers with an AGI of $220,000 or more.

What Happens to Coverdell if the Child Doesn't Go to College?

If the child doesn't go to college and does not use the money by the time they are 30, the child (beneficiary) will have the amount distributed to them and will be taxed on the amount.

The Bottom Line

The Coverdell Education Savings Account was created by the U.S. government to help pay for education expenses for families under a certain income level. The account is a tax-deferred account and must be created before the beneficiary turns 18. The total maximum annual contribution for the account is $2,000 and must be used by the time the beneficiary is 30 years old.

Article Sources
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  1. Internal Revenue Service. "Topic No. 310 Coverdell Education Savings Accounts."

  2. Internal Revenue Service. "IRS Tax Tip 2003-38. Coverdell Education Savings Account Can Make Education Costs Less Taxing."

  3. U.S. Congress. "H.R.1994 - Setting Every Community Up for Retirement Enhancement Act of 2019."

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