A Coverdell Education Savings Account (ESA) is a tax-friendly way to save for a child’s education at any level from kindergarten to college. Unlike the 529 account, ESAs can also be used for educational expenses in primary and secondary school. Contributions are fully or partly tax-deductible in most states, but are much lower than those allowed for a 529 account. Growth on the principal is tax-deferred. Withdrawals from the Coverdell Account for the purpose of paying eligible educational costs are entirely exempt from tax. Coverdell accounts are governed by section 530 of the Internal Revenue Code.
Unlike 529 accounts, the full value of the ESA, both principal and earnings, must have been withdrawn for use by the beneficiary by the time the beneficiary turns 30. Although all funds are considered to be owned by the plan’s owner, they cannot be withdrawn by the plan owner. This means that the plan owner of an ESA does not have as complete control of the ESA as he would of a 529 account. Any funds which are not withdrawn for eligible educational expenses by the time the beneficiary turns 30 are fully taxed with additional heavy tax penalties, and any tax benefits or credits may also be recaptured.
Eligible contributions to Coverdell accounts are much lower than those allowed for 529 accounts, currently $2,000 per child per year. Any excess contributions are penalized. If multiple family members each open an ESA for the same child, total contributions per year for that child cannot exceed $2,000. Contributions to the ESA can only be made while the beneficiary is under 18 years of age. They are also governed by federal gift tax regulations.
Coverdell accounts allow a wide range of investment options, including stock mutual funds, money market funds, and bond mutual funds, as well as more secure options. ESAs which include market investments are subject to standard market risks.
ESAs are subject both to age and income restrictions. If it is unlikely that the ESA will be completely spent by the time the beneficiary turns 30, the beneficiary may be changed to another eligible child. The Coverdell account is counted as an asset for the purpose of determining eligibility for other financial aid, at 5.64% of its total value. For this reason, some families choose a grandparent or other relative to be the plan owner.
Coverdell Education Savings Accounts are named for the late Senator Paul Coverdell, who spearheaded the Education Savings Account initiative.