What Is an Education IRA

An education IRA is a tax-advantaged investment account for higher education, now more formally known as a Coverdell Education Savings Account (ESA). Under this educational savings vehicle, parents and guardians are allowed to make nondeductible contributions to an education individual retirement account (IRA) for a child under the age of 18.

Key Takeaways

  • An education IRA is a tax-advantaged savings account used to pay for children's' educational expenses.
  • They are formally known as Coverdell Education Savings Accounts.
  • Educational IRAs are similar to 529 savings plans but with some key differences.

Understanding Education IRA

Funds saved under an education IRA are meant to be used to cover future educational expenses, such as tuition, books, and uniforms at the elementary, secondary, and higher education levels. The funds in an education IRA can be withdrawn tax-free when they are needed for educational purposes.

Education IRAs are also referred to as "Coverdell accounts" or simply an "ESA," and despite their "IRA" moniker, they are for educational expenses, not retirement savings, though they work in a similar way. They are similar to 529 savings plans but have some key differences.

Education IRAs existed before they were renamed Coverdell ESAs in 2002 and were made even more attractive as an educational savings vehicle when the list of qualified expenses was extended to certain K-12 expenses. They work in a way similar to Roth IRAs, in that both allow annual, nondeductible contributions to a specially designated investment account. That investment will grow free of federal taxes, and withdrawals will be tax-free as well, as long as certain requirements are met related to the year's contributions are made and the year's withdrawals are made.

The tax treatment of education IRAs is similar to that of 529 savings plans, though with a few notable differences. They are similar in that both allow for tax-deferred growth and for those proceeds to be withdrawn tax-free for qualified educational expenses at a qualified educational institution. Education IRAs are covered under Title 26, Subtitle A, Chapter 1, Subchapter F, Part VIII, Subsection 530 of the U.S. Code.

Education IRA Considerations

Education IRAs have many conditions and stipulations, such as:

  • Tax law prohibits funding an ESA once the beneficiary reaches 18 years old.
  • Coverdell ESAs have an annual contribution limit of $2,000, but a penalty may be assessed if that sum is exceeded.
  • Low contribution limits may mean that even a small maintenance charge by whatever institution holds an ESA can limit returns.
  • Unlike a 529 plan, the sum in an education IRA must be distributed to a child if not used for college.
  • ESA treatment in federal financial aid is similar to that of 529 plans—as an asset of the parent (custodian). A withdrawal is not reported as income as long as it is tax-free at the federal tax level.
  • Such an account must be totally liquidated by the time the beneficiary reaches 30 years old; otherwise it will be subject to tax and penalties.