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 non-deductible contributions to an education individual retirement account (IRA) for a child under the age of 18. 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 The funds in an education IRA can be withdrawn tax free when they are needed for educational purposes.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.
BREAKING DOWN Education IRA
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, non-deductible 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 years contributions are made and the years withdrawals are made.
Education IRA and Taxes
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 They are similar in that both allow for tax-deferred growth, and for those proceeds to be withdrawn tax free for qualified educational expenses at a qualified educational institution.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 a limit of $2,000 (up from $500 prior to 2002), 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 age 30, otherwise it will be subject to tax and penalties.