What Is a Coverdell Education Savings Account (ESA)?

A Coverdell education savings account (ESA) is a tax-advantaged investment account that can be used to pay for qualified education expenses. While these accounts are similar to 529 plans in some ways, they are much more flexible—for example, they typically have more investment options. In other ways, they are much more limited, including their $2,000 annual contribution limit.

Still, Coverdell ESAs are worth considering in certain situations. In the sections ahead, we’ll explain what a Coverdell ESA is and when you might want to use one of these accounts. We’ll also cover various rules, such as contribution limits and withdrawal rules.

How does a Coverdell education savings account (ESA) work?

A Coverdell ESA is a tax-advantaged custodial account that is set up and funded on behalf of a minor to save and pay for education expenses. These accounts can be useful if you know how they work and determine that one is right for your situation.

As mentioned, the annual contribution limit for Coverdell ESAs is $2,000. Contributions must be made in cash and are not tax-deductible. When the account is opened, the beneficiary must be under the age of 18 or a special needs beneficiary. Any individual whose modified adjusted gross income (MAGI) is under the limit can make contributions.

The IRS doesn’t limit the number of ESAs for each beneficiary. However, the combined contributions to all accounts for a beneficiary cannot exceed $2,000 in a given tax year.

The beneficiary of a Coverdell ESA can generally receive tax-free distributions to pay for qualified education expenses. However, if distributions exceed the beneficiary’s qualified education expenses, the excess amount is taxable to the beneficiary.

How to open a Coverdell education savings account (ESA)

The steps to opening a Coverdell ESA may vary depending on where you open the account. In general, these are the common steps you need to take:

Choose a financial institution

The first step is to choose a financial institution that offers Coverdell ESAs. You can open a Coverdell ESA at a bank, credit union, or financial institution that lets you invest in stocks and bonds. Not all online brokers offer Coverdell ESAs, but popular ones that do include Charles Schwab and E*Trade.

Every financial institution has pros and cons. To find the right fit, research those that meet your needs regarding fees, investment options, and customer service. Chances are, these criteria will narrow down your options to no more than a few, making it easier to choose.

Complete the application

Once you decide where to open the account, you’ll need to gather information to fill out the application, including the beneficiary’s name and Social Security number. If you won’t manage the account, you will need the same information for the account manager.

After you have the necessary information, complete the application online or by visiting a local bank or credit union branch. Fill out the application with the information you acquired for the beneficiary and the account manager.

Select investments

Now, it’s time to select your investments for the account. One of the benefits of Coverdell ESAs is they typically have fewer restrictions on investment options than 529 plans do. You can often select from stocks, bonds, mutual funds, and exchange-traded funds (ETFs). You may also have access to other investments depending on the financial institution.

Fund the account

You must fund the account to take advantage of its benefits. Remember that each beneficiary can have a maximum of $2,000 across all accounts. Contributions must be made in cash and are not tax-deductible.

Set up recurring contributions

Many financial institutions will let you set up automatic, recurring contributions. This step is optional but makes contributing to a Coverdell ESA easier. For instance, if you are the only one contributing to an ESA for your beneficiary, you can contribute $166.66 monthly.

With this automatic contribution, your total annual contribution will be $1,999.92, just under the limit. You can make smaller automatic contributions if you want, but anything larger will put you over the limit.

What can Coverdell education savings account (ESA) money be used for?

Coverdell ESAs are savings accounts that allow the beneficiary to receive tax-free distributions for qualified education expenses. One of the main benefits of these accounts is that you can use them to pay for post-secondary education as well as primary and secondary education expenses.

Primary and secondary education expenses

Distributions from ESAs generally must be for qualified primary and secondary education expenses. Coverdell ESAs can potentially pay for the following expenses, tax-free:

• Tuition and fees.
• Books, supplies, and equipment.
• Academic tutoring.
• Special needs services for a special needs beneficiary.
• Computer or peripheral equipment, computer software, or internet access.

Computer equipment and software should be used by the beneficiary or their family when the beneficiary is in primary or secondary school. Games are generally not eligible unless they are primarily educational.

Post-secondary education expenses

Coverdell ESAs can also cover expenses related to higher education. Examples of post-secondary education expenses eligible for tax-free distributions include:

• Tuition and fees.
• Books, supplies, and equipment.
• Room and board.
• Computer or peripheral equipment, computer software, or internet access.
• Expenses for special needs services.

These expenses are mostly similar to primary and secondary education expenses, with a few small differences. The common thread is that expenses should be directly related to the beneficiary’s education.

When to choose a Coverdell education savings account (ESA)

A Coverdell ESA can help pay for education expenses, but it is most useful under the right circumstances.

For single filers, the income limit for Coverdell ESAs is $95,000. For single filers with an income between $95,000 and $110,000, the contribution limit is lower than the typical $2,000. For single filers making more than $110,000, contributions aren’t allowed.

The income limits for joint returns are double those for single filers. Joint filers making up to $190,000 can contribute the full $2,000. Those making between $190,000 and $220,000 have a reduced contribution limit, and joint filers making more than $220,000 can’t contribute.

Another important consideration is the custodian for Coverdell ESAs, which can be any bank or financial institution. Once you decide who the custodian will be, you get free reign to choose any investments the custodian offers. If you prefer to select your own investments, a Coverdell ESA may be a good choice, as it offers more freedom in investment selection than a 529 plan.

What are the contribution limits for a Coverdell education savings account (ESA)?

As mentioned above, the annual contribution limit for a Coverdell ESA is $2,000. Contributions are not tax-deductible and must be made with cash (including checks). No limit exists on how many Coverdell ESAs a beneficiary can have, but the total contributions across accounts cannot exceed $2,000 a year.

If a beneficiary's contribution limit is exceeded, there may be a penalty. Given that these accounts' contribution limit is low, it’s usually best to have just one person contributing to an ESA for each beneficiary. This will help avoid going over the limit.

What are the withdrawal rules for Coverdell education savings accounts (ESAs)?

There are generally few withdrawal rules for Coverdell ESAs, which is one of their advantages. The main things to know are how to use the withdrawals, the beneficiary’s age, and the transfer considerations.

Qualified expenses

The most important withdrawal rule for Coverdell ESAs is that withdrawals should be used to pay for qualified education expenses. We covered examples of those expenses in an earlier section. If withdrawals aren’t used to pay for qualified expenses, according to the IRS, a portion of the earnings will be taxable to the beneficiary.

Age of beneficiary

The beneficiary must be under 18 or a special needs beneficiary when the account is established. Anything left in the account after the beneficiary completes their education should be fully distributed within 30 days of their 30th birthday. The only exception is if the beneficiary is a special needs beneficiary.

Transfers

As mentioned, withdrawals from a Coverdell ESA may be taxable if they are not used to pay for qualified education expenses. Transferring the funds to another eligible family member under age 30 can avoid this. Of course, it’s best to transfer the money to someone with eligible education expenses to avoid paying taxes.

Pros and cons of Coverdell education savings accounts (ESAs)

Advantages of Coverdell education savings accounts (ESAs)

Coverdell ESAs have a few advantages that can make them worth considering. Here are some of their main benefits.

Tax-free growth

There is no tax on the growth of investments in a Coverdell ESA. This means that as you invest money in the account over the years, you won’t have to pay taxes, even if your investments grow.

For instance, suppose you contribute $2,000 to a Coverdell ESA for 18 years with an average 7% growth rate. In this example, you would have contributed $36,000 by the end of the 18th year. However, with 7% growth, your interest would be about the same amount as your contributions, but you wouldn’t have to pay taxes on the interest.

Tax-free withdrawals

As mentioned, Coverdell ESAs may allow tax-free withdrawals if the money is used to pay for qualified education expenses. This helps reduce the tax liability for you and your beneficiary.

Investment flexibility

Coverdell ESAs usually have few limits on investment selection, allowing you to choose from a wide range of stocks, bonds, mutual funds, and ETFs. Conversely, 529 plans only let you choose from a limited number of options, typically a selection of mutual funds.

Coverdell education savings account (ESA) considerations

These accounts have some advantages but aren’t always the best choice. Here are some considerations to keep in mind.

Low contribution limit

The biggest downside of Coverdell ESAs is the contribution limit of just $2,000 per beneficiary per year. Even with investment growth, Coverdell ESAs may not be sufficient to cover all education expenses.

Income limits

As reviewed earlier, you must be under the income limits to contribute to a Coverdell ESA. And if you reach the $95,000 threshold ($190,000 for joint filers), the contribution limit will be less than $2,000.

Penalties for non-qualified expenses

If withdrawals from a Coverdell ESA are used for non-qualified expenses, the money will be taxable to the beneficiary. In addition, the earnings portion may be subject to a 10% penalty.

Alternatives to a Coverdell education savings account (ESA)

If you are above the income limit for a Coverdell ESA or want to contribute more than $2,000, consider some of the following alternatives instead.

Coverdell education savings account vs. 529 plan

The most common alternative to Coverdell ESAs is the 529 plan. Like Coverdell ESAs, 529 plans are tax-advantaged savings accounts for education expenses. However, 529 plans have extremely high contribution limits by comparison. There are no annual contribution limits. But how much you contribute throughout the years is limited by each state and ranges from $235,000 to more than $550,000. There are no income limits, either.

Like the funds from a Coverdell ESA, funds from a 529 plan can only be used for qualified education expenses. This includes up to $10,000 per year for K-12 tuition, as well as tuition and fees for higher education. The funds can also cover college costs such as room and board, books, supplies, computers, software, and internet access. In addition, up to $10,000 can be used to help pay off student loans.

No income limits and drastically higher contribution limits make these accounts a good alternative for high-income account managers.

UGMA/UTMA accounts

UGMA (Uniform Gift to Minors Act) and UTMA (Uniform Transfers to Minors Act) accounts are taxable accounts that allow you to gift or transfer assets to a minor without needing a trust. While these accounts are taxable, they allow you to contribute up to $18,000 annually without gift tax consequences. These accounts also have tax advantages, including some tax-free earnings. Once the beneficiary reaches the age of majority—18 or 21 in most states —they gain control of the funds.

Roth IRA

A Roth IRA is a retirement account, but it can be used for education expenses. Contributions can be withdrawn tax-free and penalty-free at any time, and earnings can be withdrawn tax-free if used for qualified education expenses (subject to certain conditions).

A custodial Roth IRA is an option if you want to open a Roth IRA for a child. The contribution limit is up to 100% of the child’s earned income or $7,000, whichever is less.

TIME Stamp: A Coverdell ESA is a tax-advantaged way to to help pay for education expenses

A Coverdell education savings account (ESA) is a tax-advantaged investment account that families and individuals can use to pay for qualified education expenses. No limit exists on how many Coverdell ESAs a beneficiary can have, but total contributions cannot exceed $2,000 annually. If used to cover qualified education expenses, withdrawals from these accounts can be tax-free. If you want to contribute more to an education savings account or are over the income limit, consider alternatives like a 529, UGMA/UTMA, or even a Roth IRA under certain conditions.

Frequently asked questions (FAQs)

Is a Coverdell education savings account (ESA) right for me?

Whether a Coverdell ESA is the right choice depends on your desired contribution and income. For instance, contributions cannot exceed $2,000 in a given tax year for a beneficiary. In addition, the income phase-out levels for those contributing to a Coverdell ESA are $95,000 to $110,000 for individuals and $190,000 to $220,000 for joint filers.

Can you have both a Coverdell and a 529 plan?

It’s possible to have both accounts, assuming you meet the income requirements for the Coverdell ESA. In addition, the combined annual contribution should be less than the annual gift tax exclusion amount.

What happens to unused Coverdell funds?

If money remains in a Coverdell ESA more than 30 days after the beneficiary’s 30th birthday, the remaining funds will be distributed and taxable to the beneficiary. To avoid this, it is possible to roll the funds over to an eligible family member under age 30.

Where can you open a Coverdell education savings account (ESA)?

You can open a Coverdell ESA at any bank, credit union, or other financial institution that offers these accounts. Some popular online brokers, such as Charles Schwab and E*Trade, also offer them.