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.
- 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 IRAs
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 The funds in an education IRA can be withdrawn tax-free when they are needed for educational purposes.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 as an "ESA." Despite their "IRA" moniker, they are for educational expenses, not retirement savings, though they work in a similar way.
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 grows free of federal taxes, and withdrawals are 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.
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 a plan holder exceeds that amount.
- 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 the age of 30. If not, it will be subject to tax and penalties.
Educational IRAs vs. 529 Plans
Both the educational IRA and the 529 plan allow plan holders to set up an account for a beneficiary of their choice. 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.
There is no limit to how many 529 plans a plan holder can set up. Contributions, though, are limited to the cost of education as outlined by the state where the accounts are held. Although accounts are set up for beneficiaries, they cannot lay claim to the funds. These plans can cover a number of different things:
- The cost of tuition
- Eligible educational expenses such as equipment
- Related expenses such as meal plans and housing
The Tax Cuts and Jobs Act (TCJA) of 2017 made changes to the rules involving 529 plans. Plan holders can use up to a maximum of $10,000 to pay for K-12 tuition from public, private, or religious institutions per beneficiary each year—penalty- and tax-free.
Additional changes expanded the rules for 529 plans when the Setting Every Community up for Retirement Enhancement Act (SECURE) was signed into law in December 2019. The owner of the account can withdraw up to $10,000 to use toward the payment of tuition and other related expenses for a beneficiary's registered apprenticeship programs. Another change includes the ability for plan holders to withdraw a lifetime maximum of $10,000 to pay down a beneficiary's qualified student debt.