Coverdell Education Savings Account (ESA)

A Coverdell Education Savings Account is a tax-deferred trust account created by the U.S. government to assist families in funding educational expenses for beneficiaries 18 years old or younger. The age restriction may be waived for special needs beneficiaries. While more than one ESA can be set up for a single beneficiary, the total maximum contribution per year for any single beneficiary is $2,000.

Formerly called an education IRA, the ESA allows families to increase investment earnings through tax-deferral as long as the funds are used for educational purposes.

For example, if you contributed $500 to an ESA and it appreciated to $5,000 in 10 years, the earnings would not be taxed until the account's owner was enrolled in a post-secondary institution. When the contributions are distributed, they are tax-free assuming that they are less than the account holder's annual adjusted qualified education expenses. The accounts in some cases can also be put towards tuition expenses for elementary schools. Coverdell ESA’s are only available to families that fall under a designated income level.

In the event that the distributions are higher than the expenses, the gains are taxed at the account holders' rate, rather than the contributor's rate, which is typically higher.

ESA’s may be established at brokerages and other financial institutions. These accounts are comparable to another tax-free college savings plan, 529, with a number of differences. There is no annual limit on the amount that may be deposited into a 529 plan. Furthermore, there are no restrictions on the income level of the contributors to a 529 plan. However, fees can be extracted from 529 accounts and the investment can also lose money as there are no guaranteed returns on such plan. It is permissible to have a 529 plan as well as an ESA for the same beneficiary’s education expenses.

The contributions put toward a Coverdell ESA must be made in cash and are not deductible. Contributions can be made by individuals with modified adjusted gross income that falls within an annual limit. In addition to individuals, corporations and trusts may make contributions to an ESA without the restriction on adjusted gross income.

Upon the beneficiary reaching age 30, any remaining funds in the ESA must be disbursed. The exception to this rule is if the beneficiary qualifies as a special needs beneficiary. It is also possible to make certain transfers from the account to members of the beneficiary’s family.