What Is a Coverdell Education Savings Account (ESA) – Rules & Limits

books piggy bankGiven the alarming rate at which universities are increasing their tuition, saving for your child’s college education can seem like a daunting task. But believe it or not, it’s almost more important when you start saving as opposed to how much. So don’t delay.

Fortunately, there are specific accounts that give you a means to invest in your child’s education and provide you with tax-advantages as well.

One popular college-saving option is known as the Coverdell Education Savings Account, or ESA.

What Is an ESA?

An ESA plan allows money that is invested and used for college to grow and be withdrawn tax-free for a named beneficiary – your child. In other words, you deposit after-tax funds and don’t have to pay capital gains tax or regular income tax on the investment’s growth, as long as it’s used to pay for qualified education expenses. Essentially, the tax treatment is similar to that of a Roth IRA or Roth 401k.

College savings accounts like the ESA and 529 college savings plan work best when started early. This is because, with time on your side, the interest you earn can compound annually while allowing you to save a significant amount in taxes.

For example, a mere $1,000 contribution earning 8% annual interest can quadruple over 18 years to $4,000. If you deposit $1,000 every year for 18 years and earn the same interest, the account value will exceed $33,000! In a traditional taxable investment, however, these earning would be markedly reduced due to capital gains tax.

What Expenses Can I Use ESA Money For?

While both the ESA and 529 plans are used to save for college, the main advantage of the ESA over the 529 is its flexibility. While a 529 plan can only be used to fund a qualified undergraduate or graduate level education, an ESA can fund either of these plus your child’s elementary or high school education.

Moreover, the ESA is more lenient when it comes to paying non-tuition academic expenses. In fact, if your child attends a public school, you can use ESA money to pay for books, supplies, and even a computer for students. Due to these attributes, as well as the contribution limits discussed below, many parents use an ESA to save for pre-college expenses, and save for college in a 529.

To qualify to use ESA funds, the beneficiary must be enrolled in school, at least half-time if they are a college student. Here are some examples of what expenses are covered by an ESA:

  • Tuition, fees, books, supplies, required uniforms, room and board, transportation, and other expenses of attending school
  • Purchasing a computer or Internet access for the use of a student (as well as the student’s family) during the years that the student is in school
  • Special needs services
  • Academic tutoring
diploma piggy bank

How Much Can I Contribute to an ESA?

The contribution limit for an ESA is $2,000 per child per year. If multiple ESAs are set up for the benefit of only one child, the total of all contributions can not exceed $2,000. Moreover, what you’re allowed to contribute may be further reduced depending on your income.

The table below lists the income limits for 2011. If you make less than $95,000, no matter what your filing status, you can contribute the full amount. If you’re married and file jointly, you can contribute the maximum as long as your income does not exceed $190,000.

If your income does exceed this, however, the amount you’re allowed to contribute will phase out to zero at an income of $220,000. All other filers cannot make more than $110,000 and still contribute to an ESA. Since this limit is relatively low, some parents choose to also establish a 529 plan, which essentially has no contribution limit.

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Withdrawal Rules

Money in an ESA account must be either spent on qualified education expenses or transferred to another child in the family by the time the beneficiary turns 30. If you break the rules, meaning you withdraw money for non-qualified purposes, you’ll not only pay a 10% penalty, but also income tax on the gains.

For this reason, it’s a very good idea to only spend money in an ESA on qualified education expenses. Furthermore, if the entire fund is not used before the beneficiary turns 30, you can either roll over the account to another child, tax and penalty-free, or cash it out and pay a 10% penalty as well as income tax on the gains.

Another reason some parents complement an ESA with a 529 plan is because the 529 does not have an age restriction.

ESA Investments

Investment options in an ESA are not limited to only mutual funds, like most 529 savings plan investments are. ESAs also allow you to invest in stocks, bonds, or CDs.

However, ESAs cannot invest in stock options, real estate, collectibles, individual businesses, or precious metals.

Does Having an ESA Affect Financial Aid?

An ESA affects financial aid in the same way as most other cash assets. Therefore, in order to optimize your child’s chances of getting aid, the ESA should not be owned by your child. This is because a student is expected to contribute 20% of his or her assets to education expenses, whereas parents are only expected to contribute 5.6% of theirs.

The financial aid office will determine that a larger pool of money is available for college if the child owns the ESA, and thereby that child will be less likely to receive aid. Keeping the account in the parent’s or a grandparent’s name takes care of this problem.

Important Considerations

  • Expenses that are paid for with money from an ESA cannot also be used to qualify for the American Opportunity or Lifetime Learning Credit tax credit programs. The American Opportunity Credit is a refundable tax credit up to $2,500 and is set to expire in 2012. If college expenses are less than or equal to this amount, you may benefit by delaying ESA withdrawals and claiming the credit instead.
  • Contributions to an ESA can begin on the date of the beneficiary’s birth, but can only be made until the beneficiary’s 18th birthday, unless they are a special needs individual.

Final Word

Saving for college doesn’t need to be difficult or complicated. Once you understand what the various accounts have to offer, you can decide which makes the most sense for you. Using an ESA account to save for your child’s education can help defray costs down the road and gives you more flexibility in investment options compared to a 529.

It can be an effective standalone account for college expenses if you cannot or do not wish to deposit more than $2,000 per year. Plus, it allows you to withdraw funds for pre-college education expenses without penalty, which makes the ESA an excellent complement to a 529.

What’s your plan for saving for your children’s college expenses? Have you used an ESA for their pre-college expenses?

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